CHAPTER SEVEN

EFFICIENCY OF MULTINATIONAL FIRMS IN CREATING

LINKAGES

The main focus of this chapter is to examine the local content utilisation rate. The

issue we investigate is - how do the changes in the nature of the global assembly sector

influence the nature of the components industry? This question is particularly important

for developing countries, mainly because many of the developing countries have opened

their auto industry to increase the development of domestic component industries.

Further, developing countries have also hoped that the MNEs presence would create the

jobs, reduce the effects on the balance of payments, of imports of vehicle parts and also

stimulate domestic technological capability more generally through spillover effects. So

the key issue that needed to be examined in the context of changing nature of global

assembling operations was how MNEs were able to generate vertical backward linkages

in the Indian automobile industry? In this regard, the study has tested as to how efficient

were multinational firms in creating linkages in the Indian automobile industry. In order

to see these variations in terms of linkage creation, the present study has tested the FDI

linkages hypothesis in the Indian automobile industry by using an unbalanced panel for a

sample of seven firms over the 1995-96 to 2003- 04 time period. Further, the study has

also estimated the firm specific efficiency in terms of linkage creation by using the

stochastic frontier analysis.

7.1. Introduction

There exists a long tradition in the development economics that foreign direct

investment (FDI) has a positive impact on industrial development in the host country. In

this tradition, multinationals (MNEs) are seen as agents that increase competition,

transfer modem technology, and help achieve a more efficient allocation of resources.

Much research has been carried out on the effects of MNEs on the host country, through

the important channels such as the results of these studies are inconclusive and often

contradictory, one important conclusion is that the host country will benefit from MNE

spresence if this can generate some kind of'deep'linkages.

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In general, linkages occur when, by design or / not, any particular firm (in this

case MNE or its affiliates) affects the amount or and conditions of supply of, or the

demand for, other goods and services by another firm or by consumers (Dunning, 1994).

Whereas, Lall (1980) has defined linkages "* as the direct relationship established by the

firms in the complementary activities, which are external to pure market transactions.

One can classify linkages" into three types: backward, forward, and horizontal. In

general, vertical backward linkages will be created when the final good producing MNEs

will procure components and raw materials from local producers in the host country.

Here, the firms not only affect their supplies of raw materials and intermediate products

by creating ancillary demand, but also influence them indirectly to increase their skills

and abilities by providing them design and new technologies. Lall (1980) has suggested

that the determination of this linkage depends upon three sets of factors. The first is

industrial type of factors: nature of production process, complexities of technologies, and

economies of scale. The Second is host country determinants: is the public policy on

local content regulation, export obligations, and other kinds of performance requirements.

Lastly: firm specific variables country of origin, corporate philosophy, and market

orientation (export or domestic market focus). The Direct linkage creation mainly

depends upon two important decisions: First, the choice between foreign or local

sourcing of inputs and raw materials, and the choice between making or buying a locally

produced input.

Forward linkages generally depend on the make or sell decision of MNEs

affiliates. In this regard normally MNEs will create linkages by opening own wholesale

or retail outlets, along with after sales servicing, maintaining, and repair facilities.

Sometimes they may also influence the performance of individual domestic dealers when

MNEs help their dealers introduce new service techniques, customer focus management

techniques, and upgrade the efficiency. Horizontal linkages arise when newly entered

foreign firms can influence existing incumbent firms in the host country producing

'"* The concept of linkages was introduced by Hirschman. See Lall (1980) for a discussion on linkages. " One can make a distinction about these linkages into horizontal and vertical. Vertical linkage can be further classified into forward linkages and backward linkages. To make the discussion easier here we have classified the linkage in the text.

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similar type of products. In general, these linkages are indirect because no MNE is ready

to disclose its expertise to domestic players. Once a multinational has set up a subsidiary,

it may be unable to prevent some of the benefits spilling over to indigenous firms through

imitation, labour mobility, competitions or exports. Such spillovers have the potential to

raise the productivity of domestic players. Exploitation of these potentials depends on the

structural characteristics of the host economy, in particular its absorbtive capacity.

This chapter has focused on the generation of vertical backward linkages because

indirect linkage effects are somewhat ambiguous and difficult to measure. Further, local

linkages are essential to the functioning of the normal industrial market, and they can

stimulate the development of the linked activities and industrial diversification in less

developed countries. In the past few years, policy makers focused their attention on

vertical or backward linkages between multinational enterprises (MNE) and local

suppliers. There are a few studies on backward linkages (Markusen and Venables, 1999;

Rodriguez-Clare, 1996). Further, it has been found in the literature of development

economics that these linkages played a vital role in influencing industrial

competitiveness, employment generation, and prevention of economies.

However, a significant growth in production had taken place in developing

countries since 1980s. This shift was the result of liberalisation of developing countries.

Prior to that, governments of the developing countries employed mainly two instruments

to support their automobile sector: promotion of national ownership and protection

policies (Barnes and Kaplinsky, 2000; Humphrey, 2000). At the time of liberalisation,

many developing countries hoped that, over time, MNEs would create local linkages. But

at the same time, believing that MNEs contribute less to domestic value added than local

firms, many developing host countries introduced policies to encourage greater local

purchase by foreign firms. These policies included granting of additional tax holiday

periods to firms that purchasd their inputs locally and imposition of restrictions on import

content .

"* Governments have used the high tariffs, quotas and licensing restrictions, manipulation of exchange rates, fiscal incentives, and limits on the import of cars (CBU) and also indulged in CKD and SKD type of

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Further, in 1993-94, the government delicensed the passenger car and jeeps

segments. The decontrol, delicensing and deregulation of the auto industry changed the

growth of the Indian automobile industry. This facilitated the entry of almost all the

global players to enter into passenger car segment in India, which increased the

competition due to sudden increase in the number of players from three to fifteen. This

resulted in dynamic restructuring, growing exposure to global competition, and increased

inflow of FDI in the Indian automobile industry. This entry of MNE car Makers changed

the risk profile of auto component suppliers.

The main objective of the Gol in liberalising this sector is to promote its

contribution towards the economy and to promote linkages. Incidentally, it designed

polices to encourage local component requirement and discouraged MNEs to import

components by using high tariffs and export obligations. In this regard, most of the

MNEs got many incentives at the time of making its location decisions. In many

instances, nations/states even competed to attract these plants to their nations/states

keeping the backward linkage creation in the mind. For example, in the case of Ford

India motors (entered as Mahindra-Ford JV with Indian company) Tamil Nadu and

Maharastra competed to get the project. This had resulted in heavy incentives from

Tamilnadu in terms of land at low cost (Ford paid only RS.300 million for about 300

acres) and Tamilnadu state had offered the sales tax concessions i.e. no sales tax for

fourteen years for goods sold in Tamil Nadu state. Apart from this it had provided

infrastructure incentives like providing sufficient power, built a new sewage plant etc.

(Venkatesan and Verma 1998). Similarly, other plants had also got these types of

incentives.

The important issue that needs to be addressed here is whether these MNEs are

creating any linkages; if they were creating how efficient they were increating these

linkages? There are a few studies, which have addressed this issue in recent periods.

Okada (2004) empirically examined the changes in the pattern of skills development for

Indian workers in domestic small firms in the 1990s. In a case study of 50 components

suppliers of MUL and Telco, it was found that assembling firms played a crucial role in

operations to help push their growing automobile sectors up the learning curve (Shapiro 1994, Barnes and Kaplinsky 2000, Humphrey 2000).

179

upgrading skills at suppliers, transforming the suppliers, transforming the supplier chain

into learning chains. Another study Vvas by Iversson and Alvstam (2004) who used single

firm level data from Volvo trucks and their 64 suppliers in India. They found that though

the operations of Volvo relied on imported CKD-vehicles it was able to influence small

suppliers by assisting them with technology and generating some important linkages.

The above mentioned studies have mainly focused on the aspect of value chain

management. Further, these case studies were descriptive in nature. In addition to that,

the important issue as how efficient were MNEs in creating linkages has not been

examined. At this juncture, the present study tries to examine how efficient were MNEs

in creating linkages as the same is more insightful and meaningful. Further, the present

study is important because its focus is only on one industry that produces homogenous

goods (i.e. passenger car and jeeps segment). And the database used here also is

important because firm level panel data allowed capturing the firm level heterogeneities

and time variant changes in terms of creating linkages.

The remainder of the chapter is organized as follows. Section II, focuses on the

globalisation led transformations in Indian automobile industry with special focus on

characteristics of Indian auto component industry; section III concentrates on the various

measurements of backward linkages and the database and methodology applied in the

study; last section focuses on empirical results and in the last section main conclusions

and policy implications are presented. It also offers a few directions for future research.

7.2. Globalisation and Transformation of the Indian Auto components Industry:

The focus of global auto assemblers has recently shifted to the big emerging markets

like China, India, and Brazil. The expanding automotive assemblers have resulted in

increase in the number of players in these countries, which has led to increased

competition in those growing markets. In this regard, MNEs who entered in these regions

have been installing the flexible production methods in order to exploit the scale

economies. Similarly, auto assemblers have started to reducing the cost of platform

development and encourage components sharing among the models. For example. Fiat

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produces its Palio car in Brazil, Argentina, India, China and South Africa. In this way

assemblers developed policies of follow design - the same design would be made at

various locations and follow sourcing the same supplier would supply a product at

different locations. Thus, MNEs have been reducing the design costs by allowing flexible

sourcing of components to different markets.

Further, MNEs in developing countries mainly depend on assembling operations

by importing CKD and SKD kits. For these assembling operations MNEs mainly depend

on the imports for some critical components that can be produced at centralized locations

and shipped to widely spread assembly sites. However, logistic costs and protectionism in

host countries initiate local production as local sourcing, is necessary. In these cases,

MNEs in the emerging markets have been encouraging their follow source suppliers. In

this regard, when global assemblers invested in the emerging markets like Mercosur

(Argentina and Brazil), China, ASEAN and India in the 1990s, the major component

suppliers were pressurised to follow them.

The important question that needs to be addressed here is how do the changes in

the nature of the global assembly sector influence the nature of components industry?

This question is particularly important for the developing countries, mainly because for

many of their countries, they have opened their auto industry to increase the development

of domestic component industries. Further, developing countries, have also hoped that the

MNEs presences create jobs, reduces the effects on balance of payments of imports of

vehicle parts and also stimulates domestic technological capability more generally

through spillover effects. So, the key issue that needs to be addressed here is in the

context of changing nature of global assembling operations, are how MNEs be able to

generate vertical backward linkages in the Indian automobile industry.

As discussed earlier, the Indian automobile industry was liberalised partially in

the mid 1980s with the entry of joint venture that radically transformed the passenger car

industry and stimulated its growth, which was till then extremely sluggish. The entry also

expanded the overall demand for passenger cars in India, leading to the industry growing

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at CAGR of approximately 25 per cent between 1984 and 1990. Further, the entry of

Maruti also forced the existing players to update those models through foreign 77

collaborations . Further, Maruti also pioneered the introduction of Japanese-style

supplier relations in India. Even though they remained limited to Maruti they exposed

firms to new practices: especially the tiering of suppliers, single sourcing, long-term

supplier relations, JV's at first tier level, tight localisation of key suppliers around the

assembler, and massive transfer of technology and continuous technical assistance to its

key suppliers.

In 1993-94, the government delicensed passenger car and jeeps segments. Decontrol,

delicensing, and deregulation led to rapid growth of the automobile industry. There are at

present fifteen players of cars and multi-utility vehicles, nine players of commercial

vehicles, fourteen players of Two/Three Wheelers. The main outcome of the

liberalisation was increase in number of firms and number of models. Further,

liberalisation also increased the capacity of the industry enormously. In the mid 1980s, it

was a tiny sector with a capacity of around 200000 units per annum. The installed

capacity had gone up tol 146000 by 2002.

Following the announcement of the new automobile policy in 1993-94, the

Government of India reduced its direct control of the automobile industry. However, the

indirect impact of government policies on the industry still remains far from insignificant.

In this regard, the Government took a decision in 1995, on companies importing

components for vehicles in the form of completely or semi-knocked down (CKD/SKD).

Incidentally, companies were requested to sign a memorandum of understanding (MoU)

with the Government and as per the MoU passenger car manufacturers have to undertake

indigenisation of 50 per cent by the third year and 70 per cent by the fifth year. In the

same time they also have to neutralize foreign exchange outflow on imports with export

of cars and components. Kumar (2003) has found that MoU regime has achieved decent

results as far as indigenisation and export targets were concerned. All the auto majors

' ' Foreign collaborations in this period were of purely technical in nature. Apart from Maruti one of them was having the financial collaboration. Thus the intensity of MNE presence was missing because they didn't have control over ownership.

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with the exception of only three auto majors - Honda Siel, Ind Auto and Fiat - fulfilled

their export obligations according to the MOU signed with the government at the time of

setting up of their manufacturing bases in the country.

The Government of India also discouraged import of components in the form of

CBU vehicles with high tariff rates. It still charges around 105 per cent customs duty on

completely built units (CBU)^l It allowed firms to import CKD and SKD backs at 30 per

cent custom duty. There are several areas where there was ambiguity in the

indigenization clause. At the moment, the duty on both CKD kits and components is 30

per cent. However, though component imports do not require any license, CKD imports

need a license. The difference between CKD and component imports had not been

specified. This helped companies to take advantage of the indistinctness. Another

disturbing element is the indigenization requirement. This had an ambiguity, which car

manufacturers were exploiting. Quite often imported raw materials, components, and

accessories sourced from third parties were shown as local content, to comply with the

MoU requirements. Industry experts say that most hi-tech components were sourced from

outside the country while only trimmings were procured locally (Sudha and Muralidhar,

1998).

With India becoming a member of WTO it had to follow TRIMS, which requires

member countries to phase out performance requirements, especially of local content

requirements. The dismantling of tariff barriers in hitherto protected economies and the

rapid globalisation of trade and investment in the auto industry in the past decade had

seriously undermined the ability of the Gol to use these instruments.

* Duty structure of the car is like this (Basic customs duty additional duty, (equal to excise duty)+special additional duty+ basic excise duty+ special excise duty+ cess) in India at 2(X)2-03. (105+32.125+4+16+8+0.125),

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Suppliers

From the beginning, the government protected the auto component industry, from

external competition by not allowing imports of components under the phased

manufacture programme (PMP). Further, the Government of India had reserved certain

items of auto components to be produced in the SSI sector . The thrust on indigenization

till the 1990s resulted in the rapid growth of component industry. This period resulted in

two effects: it created a large pool of skilled, technical workforce and it contributed to the

rise of regional auto-parts industry clusters in Tamil Nadu, Maharashtra and Delhi. By

the international standards, however, the Indian automotive component industry was

fairly small .Its total annual sales, of US $2.6 billion, places the industry on the same

scale as a single fairly large first-tier supplier like Sumitomo Electric . In fact, only eight

component manufacturers had sales turnover exceeding US $100 million in 1996.

The Indian auto component industry has had some success in developing parts

and components including collapsible steering columns, brake linings, power steering,

catalytic converters, and central locking systems. Current technology upgradation was in

plastics, trims, electronics, anti locking braking systems, and environment and safety

related items and materials. International supplier firms were looking for Indian partners

in a variety of areas. Thirteen new joint ventures were formed in 1995, and many more

technical collaborations were being finalized.

Table .7.1: Principal Characteristics of Automobile Component Industry in India

1982-83 1987-88 1992-93 2002-03

Number of firms Investment (Rs. Crore) Employment (000) Value of output (Rs. Crore)

255 80

25.5 273

384 777 49.6 1375

488 1270 60.3 3053

416 2,645 250

26472*

a. Dollar value converted into rupees as Rs 48 per $) Source: ACM A

79 Small-scale industry (SSI) refers to firms with an initial capital of Rs. 6 million (approximately US $ 150,000), regardless of size of employment. The Indian government has formulated a number of policies and programmers to protect and promote this category of firms.

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Currently there are 416 major players in the auto component sector. The industry's

output for the financial year 2001-02 was $ 6.5 billion with a growth rate of 9 per cent.

The auto component industries have been exporting more than 10 per cent of their output

for the last few years. Principal export items included replacement parts, tractor parts,

motorcycle parts, piston rings, gaskets, engine valves, fuel pump nozzles, fuel injection

parts, filter and filter elements, radiators, gears, leaf springs, brake assemblies and

bearings, clutch facings, head lamps, auto bulbs and halogen bulbs, spark plugs, and body

parts. But the other side of the story was that many of the small firms were becoming

inefficient and have started to exit from the competition. Further, the traditional small

players who are highly fragmented with low volumes and narrow product line are not

able to withstand the competition mainly because they were not able to achieve

advantages arising from economies of scale.

New entrants, who prefer to have their own suppliers in the home country (or)

their plants elsewhere, have brought their own suppliers in order to cope with local

content regulation. Companies like GMI, Ford, Mercedes-Benz, Daewoo, Hyundai,

Mitsubishi Lancer and Toyota encouraged their group of companies or their established

suppliers to create manufacturing facilities in India. But most of the MNEs had brought

their suppliers with them and MNEs also source many components from their follow

sources and source only very few components locally.

In this regard, Tewari (2001) has examined the strategies of three MNEs in

sourcing their components. He found that Hyundai, which was a fully integrated plant

and largest investment outside South Korea has only seven suppliers who were the

Korean follow sources out of 70. And the Mitsubishi, which was fully based on imported

components from Japan, had around 40 suppliers who were local, accounting mainly for

hardware, packaging, and non-critical components. Whereas, in the Ford which had a

mixed strategy of production —of imports and local production, but it operates heavily

on basis of sourcing designs and platforms from its global operations; several key parts

were imported; some produced locally, on paper, the firm had 75 per cent local content.

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but the local content is very shallow. Follow sources and JVs account for 84 percent of

value of all out-sourced parts.

Table.7.2:

Sources of Components of MNEs in India

Nature of source Imported

Follow sources

Other transnational companies

Locally-owned company

Components supplied Engine, gearbox, engine management system,

constant velocity joints Steering gear, steering wheel, rear axle, rear brake, paint, starter. Motor, wiring harness, front and rear seat-belts, instrument panel. Seats, headliner

Clutch, steering column, brake actuation, front brake, rear suspension, fuel tank, headlamp, tail-light, radio/CD, door boards, wheels Shock absorbers, glass

Source: UNIDO

From the above discussion it is clear that globalisation had changed the risk

profile of component suppliers. While there are only a few suppliers, many of them

supply components to the manufacturers abroad. Thus, as global auto assemblers that

were located in developing countries rely overwhelmingly on "follow sourcing" as a

procurement strategy or on a small elite of locally based first tier suppliers with global

reach, while existing supplier networks got progressively undermined and marginalised.

But, other firms which are fragmented with small size and less technological know how

are exiting in the competition. It is important to study empirically how efficiently MNEs

are creating linkages, by examining their local content over a period of time.

7.3. Database and Methodology:

The decision of an MNEs to source locally often depended upon the technological

level of the local supplier and has capacity to respond to the MNEs standards. Further,

MNEs chose to outsource at least some of their intermediate inputs locally, one reasons

for that decision could be attributed to the policy measures such as "local content", high

tariffs on inputs, or constraints imposed by the nature of production technologies such as

just-in-time inventory (Rodrik, 1995). These linkages appear to be a "win-win" for the

participants in this regard the MNE can reduce its production cost, while the local

supplier benefited from higher demand and, eventually, higher technology transfer.

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There are various indicators regarding measurement of linkages which go beyond

the simple measures of import propensities or even local purchases of inputs. In linkages

involve the broader array of externalities, which may be spurred by the operation of

multinational enterprises. The first indicator is the inverse of Leontief matrix. Rodriguez-

Clare (1996) has measured the generation of linkages by the ratio of employment

generation in upstream industries (through demand for specialized inputs) to the labour

hired directly by the firm.

The study had used the import dependency ratio for measuring linkages. A

number of studies have used this measure to find the differences between linkages

generated by domestic and foreign firms. In general the volume of vertical linkages

generation depended upon two important decisions of the firm regarding the sourcing of

the raw materials and intermediate products: "imported or procured locally" and "make

or buy". The first decision will be explained by the import content in their expenditure.

And the second decision will explain the vertical integration of firm. As a rule, vertical

integrafion is defined as a percentage to value added to sales ratio. If the final firm takes a

decision to procure from the local producer then there is a scope that the supplier will

benefit from the technological transfer also. So, for measuring of linkages we are using

the import dependency of a firm which has been defined as a rafio of amount spent on

import of raw materials and intermediate inputs to total expenditure on the materials and

parts.

Import dependency (Id) = CIF value of imported raw materials and components

Total raw material expenditure

The degree of local content utilisation has been defined as (1-Id) per cent. Higher

the content of intermediary goods used by the firm; higher is the degree of backward

linkages; higher the import dependency, lesser will be the scope for backward linkages.

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The size of the local market and the technological level of the MNEs influence

determine the degree of vertical linkages. Further, the linkage was also related with the

technological gap between the MNEs and theirs local competitors. The fact that MNEs

had a very large technological advantage over the local firms indicates that the demand

for the intermediary goods would become minimal. Further, earlier literature has shown

that the degree of backward linkage in a closed economy for any country would be

positively associated with the home market size and negatively with the supplier's unit

labour requirement.

From the above, it is clear that the degree of import dependency (Id), which was

important in determining linkage, has often dependent on the technology level capint of

the firm and the share of labour cost ws. Here capint is defined as a ratio of gross fixed

assets to total labour . Further, the wage share is defined as wage bill upon sales. An

automotive firm cannot gain a sustained competitive advantage by simply increasing its

rate of investment. Therefore, we include capital stock per worker, A/L, as essentially a

control variable in our study. From the above details one can present this relationship for

ith firm in period as shown below:

Inidi, =/( Incapintit,Inwsj,) Where as i=1.7, and t=1...12.

This can be expressed as a linaer model by using the stochastic frontier model to be

estimated*' for unbalanced panel data for the i th firm for the period t in this form.

Inidj, = a+Pi lncapinti,+ P2lnwsi, +Vi,-Uii

Where Vit are random variables which are assumed to be iid. N (0,Ov^), and independent

of the Uit, which are non-negative random variables, which are assumed to account for

technical inefficiency in the model and are often assumed to be iid. |N (0,Ou^)|.

7.4. Stochastic Frontier Production Function:

Let as assume that the actual production function of a firm can be written as Qi,=/(Xi,;6)exp(-Ui,) ...(1)

Where as 0< Ui,<oo i=l.N, and t=l...T

*" Wage bill of labour has been substituted for labour owing to non availability of labour data. *' For estimation purpose we have used Frontier 4.1 package

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Where Qit represents the actual output for i''' sample firm in the period t: xit is a

vector of inputs and 6 is the vector of parameters that describes the transformation

process; f(.) is the production function and uit is a one sided (non- negative) residual

term. By taking log on both sides the above-mentioned function will become like

lnQi,=/In (Xi,;6)-Ui, (2)

If we assume that firm produces an efficient level ^of production then the

production function of firm can be written as

lnQ*i,=/ln (Xi,;6) (3) One can measure Technical efficiency (TE) as a ratio of the actual output Qi t to

potential output of a firm f (.) then we can write TE as

ln(TE)i, = InQi,-lnQ*i, =-Ui, (4)

l b j i = e jt

Note that the residual term Ujt is zero when the sample firms produces the

potential output and is less than zero when production is below the frontier (less than full

E) From the above discussion one can write a general stochastic production^'' function as

expressed in the following form:

lnQi,=/ln (Xi,;|3) + Vi,-Ui, ,i=l,.,N, and t=l,....T (5)

Where Qi, is the production (or the logarithm of the production) of the i-th firm at t-th

period; Xi, is a kxl vector of (transformations of the) input quantities of the i-th firm*"* at

t-th time period.P is a vector of unknown parameters; the Vi, are random variables which

are assumed to be iid. N(0,av^), and independent of the U,, which are non-negative

random variables which are assumed to account for technical inefficiency in production

and are often assumed to be iid. |N(0,Ou^)|. This sp)ecification has been used in a vast

number of empirical applications over the past two decades. The specification has also

been altered and extended in a number of ways. These extensions include the

"^ If the operation of the unit is efficient (inefficient) the actual output is equal to (less than) the potential output " The stochastic frontier production function was independently proposed by Aigner, Lovell and Schmidt and Meeusen and van den Broeck in 1997 . The original specification involved a production function specified for cross-sectional data, which had an error term, which had two components, one to account for random effects and another to account for technical inefficiency. For references See collie (1994) "''For example, if Qj is the log of output and Xi contains the logs of the input quantities, then the Cobb-Douglas production function is obtained.

189

specification of more general distributional assumptions for the Uj, such as the truncated

normal or two-parameter gamma distributions; the consideration of panel data and time-

varying technical efficiencies; the extension of the methodology*^ to cost functions and

also to the estimation of systems of equations; and so on.

In this regard, Battese and Coelli (1992) have proposed a stochastic frontier

production function for (balanced and unbalanced) panel data that has firm effects, which

are assumed to be distributed as truncated normal random variables, which are also

permitted to vary systematically with time. The model may be expressed as: by using

equation (5), which considered the TE effect of firm i in sample in period t (i.e. U,,) is the

product of random variable and the exponential function, whose value depends on

parameter (r|) and remaining time periods (t-T).

Ui, = Tii, Ui= (Uiexp(-T|(t-T))), (6)

where Ujt are non-negative random variables which are assumed to account for technical

inefficiency in production and are assumed to be iid as truncations at zero of the N

()i,Ou ) distribution; T) is a parameter to be estimated. This r\ can be used to verify the

firms TE increases, remains the same or decreases over time by examining r\ is positive,

zero or negative (T|=0 will give the case of time invariant model). The additional

restriction of |i equal to zero reduces the model to model to half normal.

One can estimate this model by using the maximum likelihood estimates (ML) .

Further, one can replaces Oy and au^ with a =Ov^+Ou^ andy=Ov^/G^. The parameter, y,

must lie between 0 and 1 and thus this range can be searched to provide a good starting

value for use in an iterative maximization process. If the all firms in the model are full TE

then the Y will become zero. In this case, the deviations from the frontier are due to white

noises Vi,. Similarly, when y=l then the deviation is purely due to the inefficiencies.

' A number of comprehensive reviews of this literature are available, such as Forsund, Lovell and Schmidt (1980), Schmidt (1986), Bauer (1990) and Greene (1993). For references See collie (1994

** As it state earlier in equation (6) TE measure is given as conditional expectation of exp (-Uit) for given composite error term ^it =(Vit-Uit) the model can be estimated with ML method

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The imposition of more restrictions upon this model, the formulation can provide

the special case of this particular model, by setting {r\ =Y=ji= 0) provides the full time-

invariant half normal model. There are obviously a large number of model choices that

could be considered for any particular application. For example, does one assume a half-

normal distribution for the inefficiency effects or the more general truncated normal

distribution? If panel data is available, should one assume time-invariant or time-varying

efficiencies? When such decisions must be made, it is recommended that a number of

alternative models be estimated and that a preferred model be selected using likelihood 87

ratio tests . One can also test whether any form of stochastic frontier production

function is required at all by testing the significance of the y parameter. If the null

hypothesis, that y equals zero, is accepted, this would indicate that C\/ is zero and hence

that the Uii term should be removed from the model, leaving a specification with

parameters that can be consistently estimated using ordinary least squares.

This methodology can be applied here to estimate^^ the model by using

unbalanced panel data for i- th firm for the period t in this form

Inidj, = a+Pi lncapintjt+ P2lnwSj, +Vit-Ui,

whereas Vj, are random variables which are assumed to be iid. N (0,av^), and

independent of the Ui,, which are non-negative random variables, which are assumed to

account for technical inefficiency in the model and are often assumed to be iid. |N

(0,au')|.

The database used here is from Capital online, which produces details on financial

performances, and for the analysis we have considered only 7 firms data ONE available.

Data for many MNEs like GM, Toyota, Fiat, Mercedes Benz and Skoda are not available

because they are not listed companies and they do not report financial statistics to BSE or

other official sources. Further regarding two domestic firms Mahindra and Mahindra and

*" . In this case the Hkelihood ratio statistic has been shown to have a mixed chi-square % distribution with degrees of freedom equals to number of restriction imposed. For more on this point see Coelli (1994).

"" For estimation purpose we have used Frontier 4.1 package

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Telco data is not considered because they are multiproduct firms and do not separate data

on passenger cars production. Time series data available for each firm vary from 1993-94

to 2003-04, finally this one an unbalanced panel data with total 51 observations .The

details of the firms is presented in Table no. 7.4. The methodology employed here has

many advantages. It does not require data for all periods and this means that the

methodology will work without any problem for unbalanced panel (which is the case here

in the study). Further, it also provides a measure of TE variation for each firm in each

time period, which will be very useful in the policy analysis.

7.5 Empirical Results:

Table.7.3: Estimates of Stochastic Frontier Production Function for Import Dependency of

Passenger Cars in India

Parameters

Constant

In (wage share) In (capint) a" y M n R2/ likelihood ratio

X Number of iterations N

OLS

Coefficients

-1.99 -0.056 0.226 0.263

36.83

51

SE

0.221 0.089 0.081

MLE

Coefficients

-1.3691 -0.032 0.1489 0.3598 0.44

0 0

36.036 1.58 12 51

SE

0.822 0.144 0.118 1.772 1.158

The estimated results of equation 1 have been displayed in the Table. 7.3 for

comparison purpose. Both OLS and ML method of estimation have been given along

with the SE of the estimated parameters. Examining the OLS estimations explains that

only capital intensity variable is showing significance along with the constant term. And

the other variable wage share is insignificant with negative sign, which explains that the

cost of labour in Indian case is not an important variable in determining the import

dependency in Indian automobile industry, whereas the other variable capinst has a

192

positive sign and is significant at 1 per cent level, which explains that level of technology

really, plays a role in explaining the import dependency. Further, it can be explained that

for one per cent increase in the level of technology there will be 0.22 per cent increase in

import dependency rate. The results from ML method also have expected signs to the

parameters. In this model both CT, y are positive and the first one is significant which

explains that the ML specification is a better fit. The estimated value of .y is in the range

and shows 44 per cent, which explains that about the 45 per cent of the difference is

between the observed and frontier is due to the technically inefficient performances. The

assumption of n=r|=0 made the present model as to assume the half normal and time

invariant model.

Table.7.4:

Firm Specific Technically Inefficiency Measures

Firms

Daewoo Motors

Hindustan Motors

HONDA SIEAL India

Hyundai Motors

Ford India Ltd..

Maruti Udyog Ltd..

Primer Automobile

Mean in efficiency

Time period

10

10

5

5

2

10

9

Technical

inefficiency

(Per cent)

9.903

31.47

16.04

23.748

13.289

37.546

46.93

25.6

The Table 7.4 explains the score of inefficiencies^^ in terms of creating linkages

here the two domestic firms Hindustan Motors and Premier Automobiles and joint

venture with government firm MUL is considered to be most inefficient in terms of

import dependency. Other multinationals are more import dependent. The level of

operations they are operating might explain this. The efficiency scores of firms explained

that two old Indian firms PAL and HM have been shown as less efficient in terms of

import dependency, which explains that they are using more local content than other

* This scores has been obtained by (1-TE) *100 formula

193

firms. Even though they used to depend less on import in terms of linkage creation has

been less because of highly vertical integrated production facilities. These two firms from

the inception in early 1950s have been vertically integrated and they have in-house

production for manufacture of critical components like engine production, gearboxes,

electronics pistons, press shop and assembling and sub assembling. For the other

remaining items it depends on small component manufactures, which has been reserved

for small scale industries. Further, their performance after 1993-94 started to decaying

and their production stated decline and both together has less than 4 per cent market

share.

And the other important factor that needs to be mentioned about their strategies is

that MNEs used these two firms to enter into the market. In this regard, General Motors

(GM) used HM as its joint venture (JV) partner at entry level and after that the GM

became 100 per cent entity after purchasing 50 per cent share from HM, Currently HM

has technical collaboration with Mitsubishi for its Lancer car and Pajero model. So, from

this we can say that this firm is less depended on import for its components linkage

creation. Further, HM has collaborated with Isuzu of Japan for manufacturing engines

and thus it has shifted its strategic focus mainly from car production to engine

manufacturing. Further Premier Automobile also had been used by two MNEs, which

entered after liberalisation: French firm Peugeot, which entered in 1995 to produce its

cars by importing CKD /SKD kits later exited from Indian market in 1997. And Italian

firm Fiat also entered as 50 per cent JV with Fiat. Later, Fiat taken over the PAL's

production unit. At present PAL almost exited from the market. Parenthetically, from the

beginning, though these two firms were less import dependent, at the same time, their

backward linkage creation is less because of higher vertical integration.

Another firm, which was less efficient in terms of import dependency, was Maruti

Udyog Limited (MUL), which is less vertically integrated than PAL, HM and depends

mainly on the suppliers for many critical components. It represents an industrial structure

with the firm relying on supply chain for almost three fourth of all inputs by value. In this

way Maruti was generating more linkages. Further, the better performance of Maruti in

terms of cost, profitability, productivity and other competitiveness indicators is mainly

194

dependent on the costs, reliability and overall performance of their suppliers. MUL since

inception encouraged entrepreneurs to set up its suppliers and used many small domestic

suppliers for its operations. Incidentally it has created enormous backward linkages.

MUL also has been influencing its suppliers; by introducing them to Japanese work

organization practices like lean production techniques and quality control circles, in firm

training programmes. By serving as model for diffusing such practices among its

suppliers MUL has proven that vertical inter firm linkage plays a role in the diffusion and

transferring of technology to its suppliers.

In contrast to its other MNEs like Daewoo, Hyundai, Ford and Honda preferred

to depend more on import of CKD/SKD kits for its assembling operation. Thus, it

explains that these firms are less involved in linkage creation. Apart from the Maruti and

other domestic firms' strategies these firms adopted the other sourcing strategies like

follow sources; in passing they encouraged many suppliers to create manufacturing

facilities in India often to form joint ventures with Indian suppliers. Thus, many global

suppliers such as Delphi, Lucas and Denso entered India.

7.6. Chapter Summary:

The present work, which tries to examine the efficiencies of firms in terms of

creation of backward linkages by using stochastic production funcfion, has found that

after the announcement of new auto policy in 1993-94, many MNEs entered into the

automobile industry. As a result of it, FDI in this segment increased along with the

increase in the capacity of production, and the consumers choice has increased with better

qualities and new models. But one of the main intentions of Gol that is increasing the

backward linkages did not happen at the desired level. The increasing pressure of global

players has changed the risk profiles of many component suppliers. And many small and

medium firms with out scale effects are exiting from the industry. The increased

competition along with new suppliers arriving in India and with new vehicle

manufacturers forced the local component manufacturers to improve the quality of their

products. However, despite its recent growth, the automotive component industry is still

195

limited in terms of technology, quality, and productivity. To strengthen their own

supplier bases, local large business houses such as the Tata group (of which Telco is a

member firm) and the Birla group (of which HML is a member firm), as well as local

vehicle producers such as Mahindra and Mahindra, have all set up joint ventures with

global suppliers to produce components. For example, the Tata group set up 5 joint

ventures with 5 foreign component producers (1 U.S., 1 French, 1 German, and 2

Japanese) to produce 7 components in a "Greenfield" supplier park in the state of Tamil

Nadu in 1997(Okada, 2004).

The degree of backward linkages creation is low. But there were some

unanticipated consequences of MNEs, wherein some of the MNEs started sourcing some

components from India to their affiliates elsewhere. Suzuki is using India as its base for

exporting the alto, Hyundai trying to make India as its export base and GM is sourcing

engines from HM. Thus, MNEs entry has transformed the local auto component industry

by making them update their technologies by putting pressure and exposing them to

world export market. In this process there are a few gains as Indian firms like TVS have

emerged as big players. But all this happened because of Gol restrictions on local

content and export obligations. In the last decade because of the local content rules they

used to source some components from India but as has been discussed above, this rule

may not be applicable in Indian context with WTO TRIMS agreements.

The multinationals like General Motors, Ford, Fiat, Daewoo and others have had

their own vendors like Delphi and Visteon following them. For example, Delphi alone is

a $36 billion company whereas the total auto component industry size in India is about $3

billion which shows the size of Indian auto component industry. Tier I suppliers are the

Delphi's and the Visteon's who have worked with their own manufacturers in other

countries as well. So, the Indian auto component makers may eventually become Tier II

and Tier III suppliers. Here the component manufactures will have some problems in

competing with Delphi's and others without any protection. But, the opportunity for India

is still there. The Indian components competitive edge lies mainly in low cost advantage

primarily on account of availability of low-cost highly skilled manpower. If we compare

196

the wage/sales ratio of USA and EU with India, there it ranges between 25 to 30 per cent,

whereas in India it is only between 3 to 10 per cent. Another advantage in Indian

component industry is the strong focus on telematics by leveraging India's strengths in

information technology by (CAD/CAM). This came as a learning experience, especially

for the small and medium units not clued in on the operations of the global auto industry.

Many of them, for the first time have learnt the rigours of doing business with global

original equipment manufacturers (OEMs).

Table.7.5: Details of follow source suppliers of Lancer car project in India

Company Madhusudan-Nippon Sona-Koyo Seiko Panalfa-Sankiekk SES-Catler Wheels-India Sathya Hindustan Everest I Exide-Shinkohe Wipe Trice Abishek-Kwan Jin takata Roots- Robert Bosch Dense India-Dense Mandarika - Tokairika Asahi India - Asahi Vijayjeyti-namba press

Product Per cables

For power steering and pinien Exhaust system Catalytic converters Wheels Battery and jack holder Tools Battery Wiper arm and blade Power window and seal belts Hem Wiper motor and link STG colomn switch Glasses Seat assembly

Source: CMIE

197

Table.7.6: Details of follow source suppliers of Hyundai Motors in India

Company

JBM Sung woo Mando Brake Systems India Lumax Samlip Industry Iljin Automotive Ltd..

JKM Dalim Automotive Penta Daewha Auto Parts PHC Manufacturing Visteon Automotive India Hanil Rear India Changyoun India Hwaseung Kyungshin Samyoung Cable Hwashin Dong-A Hwasung Hyundam Industry Shinhan Plasto

Collaboration (*)

JBM (50), Sung woo (31), Mitsubishi (19) Anand (75.8), Mando (24.2) Samlip (75.2), Hyundai(4.5), Lumax (20.3) Greenfield

Dynamic (73), Dalim (27) Daewha (51), Penta (49) Component Speciality (50), PHC (50) Visteon (94), Hania Kongjo(6) Hanil (50), Rear (50) Anand (76), Changyoun (24) Hwaseung RNA (74), 1-Alpha (26) Kyungshin (50), Mothersn (50) Greenfield Greenfield Greenfield Greenfield Greenfield

Product or

Activity

Car body Brake system Lamp, trim Engine parts, TM parts Oil pump, water pump Oil lamp, oil filter Door latch hinge Aircon system cluster Seat, interior Ring-synchro Lever, pvc, profile Wiring harness Battery cable Chassis Rubber parts Fuel pump Crash paid

Source: Park (2004) (*): ratio of stock ownership

198

Table.7.7: Local content commitments of various firms in India

Name of the company Japanese firms

Honda SIEL India Ltd. Toyota kirloskar motor pvt Ltd..

Mitsubishi lancer car project

American firms

Ford motors India pvt limited General Motors India pvt Ltd.

European firms

Mercedez Benz (India) Ltd. PAL Peugeot Ltd..

Fiat India pvt. Limited Skoda India Ltd.

Korean firms

Daewoo Motors (India) Ltd. Hyundai India Ltd..

Indian firms

TELCO indicia car project Mahindra and Mahindra Scorpio project

Starting year

45 54 47

40 50

10 15 30 10

30 70

90 90

Target

65 70 n.a

70 75

70 80 80

80 85

90 90

Source: various (JV ) joint venture TC technical collaboration WOS: wholly owned subsidiary, Na: not available

199

Chart.7.1

Vertical Integration of Indian Atomobile Firms in 2000

45

40

36

30

» 20

16

10

5

0

|VI(m%)

Source: CMIE

200