Why Nokia won't 'Make in India'. Vietnam beckoned; the taxman and rupee pushed

The long running Nokia saga at Sriperumbudur, near Chennai, is reaching its final denouement. The latest announcement about the closure of production at its "feature phone" plant may bring to an end a story that started in 2006. The narrative has enough angles to make it the subject of a famous business school case study. One is reminded of that truism about the dog in the Sherlock Holmes story Silver Blaze. Holmes fans will remember that the dog did not bark, and that was the problem. The focus is on what did not happen, which was more significant than what did happen. In Nokia's case they invested in India. That is what happened. Why did they not invest in India to begin with? Or to put it differently, why did they come to India in the first place? That is the really interesting question.

The parlous state of Indian manufacturing is too well known and will not be gone into here. Manufacturing's share in the country's GDP - now down to about 15 per cent - has been falling steadily for years. Successive manufacturing indexes bring out the story quite well. Yet Nokia went where nobody treaded before.

The story is a complex and fascinating one. Most analysts have indulged in the usual " hai hai, tauba tauba" routine, and drawn the obvious conclusions about what the incident says about the dreadful conditions in domestic manufacturing. Presumably, after a while, the incident will be viewed as a minor awkwardness to be swept under the carpet as "animal spirits" revive with a stable government and reform efforts. Both attitudes would be a mistake.

It does seem embarrassing for a government so focused on reform and "Make in India" that the biggest project by an MNC in this area should be on the way out. But in this case, domestic conditions interact with complex supply chain and corporate strategy decisions by a seasoned multinational competing in global markets. Shifting international comparative advantage among nations also plays a role in the story, as do macroeconomic variables. Finally, there is the role of government policy in a country with a broken down tax collection and legal system. Disentangling these factors will be the task of this essay.

Entry...Followed by a Cluster

That Nokia's investment in 2006 happened at all was a miracle. Nokia's supply chain model relies heavily on vertical integrators (VI) and component suppliers. The VI s actually sub-assemble parts of the phone, and the sub-assembled parts, together with the supplied components from other vendors, feed into a massive Nokia assembly plant. This provides economies of scale and cost leadership, the only thing that matters in producing what has become a commodity.

So important was the Nokia investment at Chennai that the company's supply chain management model had actually morphed into two. There was the Xing Wang model and the Chennai logistics model. In the Xing Wang model, most of the vertical integrators and suppliers were located in China. The reason is not difficult to see. Economies of scale in large scale manufacturing of cell phones are in China - and China only. In fact, China makes more than half the world's cell phones. In the Chennai model, only some of them were located in China. The rest were located near the Nokia plant itself, in the cluster near Chennai. This model attempted to reduce Nokia's reliance on VIs in China. Despite logistics costs on the production side, there was also the advantage of being located close to major markets; and India in 2006 was an exploding market for low-end feature phones.

The Chennai model was also implemented at Cluj Nabona in Romania, but that plant was closed in 2011. Chennai would be shut three years later. Clearly the model worked till it stopped working. What was that model all about?

Most economists, industrialists, and media commentators seem to think that India's low manufacturing wages are a godsend, and the best thing since sliced bread. In fact, they are only a small part of the story when it comes to complex international sourcing and investment decisions. As important as low wages is the cluster, especially when it comes to manufacturing in electronics, particularly cell phones. The cluster refers to the geographical concentration of suppliers and vertical integrators in a given area.

Scale economies and technological interdependence create advantages in industrial clustering, as Paul Krugman's pioneering work in the area points out. Skilled labour markets develop around these clusters, and that, combined with reduced transaction costs, creates huge advantages to firms. Assuming manageable transportation and logistics costs, together with the inevitable coordination costs, firms will cluster and service global markets from a single location. Government policy can aid these vast forces - what people call globalisation - and push them in a certain direction to a country's benefit. But only up to a point.

Nokia's investment in India must be seen in this light. For a relatively small investment of about Rs 2,000 crore, by Nokia and its integrators, the company sought to create an entire industrial cluster - what trade jargon calls an ecosystem - at Sriperumbudur, near Chennai. The plant was set up in 2006, before the smart phone era. The focus was on feature phones - nomenclature for phones that are not smart phones - and when Nokia was the world's dominant cell phone manufacturer. Production was dominated by the low-end Asha series. Setting up an entire cluster also made sense because of the huge market for these phones near the cluster. The idea was to start Sriperumbudur as a cluster to rival Shenzhen or Dongguan, both in China. Sriperumbudur at that time was beginning to attract international majors in automobiles like Ford and Hyundai, primarily due to its proximity to Chennai's harbour, and the area's auto manufacturing expertise.

Nokia sought to replicate the auto story in electronics with attendant payoffs. Clusters, when set up on a large scale, tend to become larger, snowballing into a centre in a complex global supply chain. Virtuous cycles of lower transaction costs, skilled labour markets, logistic proximity, and technological interdependence come into play. This was what Nokia was trying to do.

Made in India? Really?

And yet the central question remained. In a country with no manufacturing experience worth the name in electronics, how to actually make the little jijits and widgets that go into a cell phone ? The answer was simple; don't make them at all!

Nokia, in essence, got its vertical integrators (VIs) and component suppliers together, and invested in giant assembly plants where assembly was done by hand to take advantage of cheap local labour costs. The role of the VIs was critical because silicon-level production equipment was very expensive, and best left to them to procure. These included the big names in the business like Jabil, Foxconn, BYD, Salcomp, and Perlos.

About 8,000 full-time jobs were created, but the actual employment was about 30,000 if you throw in the integrators and suppliers. Most were women, perhaps because women have the fine hands needed for close-order assembly.

The key in all this is low transportation costs. You cannot do this with steel or automobiles. But cell phone components can literally be flown in as cargo, via jumbo jets. Which is what actually happened here. The jijits and widgets that went into the phone came in giant jumbo jets from Shenzhen and Dongguan in China. The parts were transported by air, - sea transport is too leisurely given the brutal efficiencies demanded by the global supply chain in cell phones - and assembled by hand, by workers on low wages. The unassembled components were easier and cheaper to transport than the sub-assemblies, or the boxed phone itself, hence the arrangement.

Display, process, and memory chips, the key components of a cell phone, were all "off the jumbo", so to speak. The only components made in India included the outer casing and the cardboard packaging, items that constituted less than 5 percent of unit cost. Even the simplest components, the keypad and the charger, all low tech items, could not be manufactured to scale at Sriperumbudur. This policy of complete component import also extended to the VIs. For instance, Foxconn imported and assembled electronic components, BYD did the key mats, and Salcomp manufactured chargers. The widgets to make these were also imported from China!

Yet, in a ruthlessly cost-competitive business, it made sense. The labour cost that went into the phone was a saving, and the assembly line workflow was deliberately designed to be labour-intensive. Besides, the hugh domestic market for feature phones in India meant a ready market for the output.

Nokia's idea to develop an entire cluster flew in the face of existing industry conditions. It was also a hugely ambitious undertaking. The reason is that China's comparative advantage in cell phones is almost unbeatable. The only critical factor, besides labour costs, in cluster development is the existing volume and density of the VIs in the area - the Foxconns and the Jabils. And on that, China with Dongguan and Shenzhen, and the concentrations there, has scale.

Nokia's move to reduce its reliance on them was commendable. Evidently, it was also not enough.

.. and Along the Way

Nokia's pure-play labour arbitrage was initially a sound business model that was taken to its logical conclusion. By 2011, the complex had produced 500 million units through a low-mix/high-volume strategy, making it Nokia's largest plant by output worldwide. Output was so large it actually affected the balance of trade figures between India and other Asean countries.

Recall however, that exposure to the exchange rate was considerable, because of the model's total reliance on imports. Any major movement in the exchange rate - particularly a rupee-dollar depreciation - would have rendered many of Nokia's 2006 calculations meaningless. In fact, the rupee-dollar pair depreciated from 45 to 60, between 2006, when the plant started, and the present day. This secular depreciation in the rupee raised the landed cost of the imported component of the cell phone's cost structure. Given the model's total reliance on imports, that meant between 90 to 95 percent of the unit's cost, clearly an unsustainable situation. It also reduced significantly the benefits of labour arbitrage from the plant.

At the same time, the market moved to smartphones. Apple and Samsung emerged as leaders, and Nokia missed the bus. Financials deteriorated to the point where the company became a takeover target and Microsoft duly obliged. Suddenly that hugh domestic market in India did not make much sense, when the market itself had shifted. Nevertheless, there was still enough of a market for the feature phones in India to provide a continued rationale for the plant's huge output. The only question was whether it needed to be served from the Chennai plant, or some alternative.

It so happens that in today's globalising world, there's always an excellent alternative.

Good Morning, Vietnam

Ricardian comparative advantage, when it is not driven by natural endowments of countries, is a shifty thing. When that comparative advantage is "created", as in an industrial cluster at Chennai, it does not stem from an inheritance of nature. It can then change surprisingly fast in today's age of globalisation.

Time was when the Red River delta in Vietnam would have been in the sights of a US bomber pilot. Today it is in other people's sights, for a different reason. Bac Ninh in the Red River delta is a typical Vietnamese province. Vietnam's government, ruthlessly proactive as only a Communist government set on reform can be, is developing with Singapore the Vietnam-Singapore Industrial Park (VSIP) there. The site is just a 100 miles from the Chinese border at Guangxi, and equidistant from Hanoi and Noi Bai international airports. Obligingly, the Chinese and Vietnamese governments are also building a highway between nearby Hanoi and Shenzhen, making it easy for trucks travelling between Guangxi, Guangdong, and Vietnam. The Asean free trade zone is next door and also well connected. Labour costs in these Vietnamese provinces are favorable relative to those in Shenzhen, and almost all of China.

Samsung is already there, as is Foxconn on the VI side, so the cluster is falling into place. Foxconn, for example, established manufacturing in northern Vietnam in 2010, and presently operates five facilities in Bac Giang and Bac Ninh provinces.

Lower labor costs, combined with the close proximity to an existing cluster, made this a valuable location for Nokia's consideration, and the company joined the cluster there. Nokia's Bac Ninh plant went online in mid-2013, about the time Nokia's tax problems started in India. The ramp up from 275 workers to over 10,000 took place by mid-2014. Production from the unit will be at about 200 million units by 2018. Initial investment was about USD 300 million, not counting the VIs, and the location was predictably in the Vietnam-Singapore Industrial Park. The arrival of archrival Samsung earlier, together with Nokia, effectively announced the VSIP as a cluster that had come of age. Nokia's Romania production at Cluj Nabona had already shifted earlier, and Sriperumbudur followed.

With Bac Ninh's advantages, and the cluster in place, Sriperumbudur never had a chance. The logistics of moving the components by road or rail to Vietnam from China are vastly cheaper than moving them by plane to Chennai. Vietnam's provincial wage rates are not very different from India's. China's yuan peg is also a much easier exchange rate environment to negotiate than India's "managed float" exchange rate regime which not many people seem to have a clue about.

Finally, and most importantly, the Vietnamese tax code is a small book that can be put in a drawer.

The Law is an Ass

The unusual feature of Nokia's legal and tax disputes in India is that they arose in 2013, a year after reports surfaced in the trade press of Nokia's entry into the Bac Ninh cluster. Magically, the Central Board of Direct Taxes had nothing to say about Nokia's tax issues from 2006 to 2013.

The tax disputes comprise two separate cases. The first is a service tax dispute with the Centre, and the second dispute concerns non-receipt of a value-added tax refund from the state of Tamil Nadu. The first dispute has resulted in demands for a bizarrely large amount even by the absurd standards of Indian tax authorities. The first tax demand with penalties, interest, and 'anticipated liabilities' is for Rs. 21,000 crore, (USD 3.5 billion). This is almost half of Nokia's worldwide market value as judged by the amount Microsoft paid for it. Just the tax demand from a single country out of the 150 countries Nokia operates in was almost half its world wide market value. Try making sense of that.

On the service tax dispute, the revenue department's argument was that Nokia failed to deduct service tax on Rs 25,000 crore in royalty payments made to its Finnish parent for proprietary software used in the handsets manufactured at the plant. Revenue then froze Nokia's assets, following which the company appealed, and lost. As is often the case with India's absurd legal system, the two parties are now reduced to bargaining in court over the amount. Disputed amount 100; Party A says, "For the moment, pay 20"; Party B says, "Will pay 10"; Court says " Pay 15". The temple of justice has become a fish market. After the bargaining, the case will presumably degenerate into a maze of technicalities that only the lawyers seem to understand, and even they do not.

What this says about Nokia's Indian lawyers is another thing altogether. Recall that Nokia must have been following the advice of its "learned friends" when it went ahead with its tax planning. Presumably, they received hefty fees for all this when they offered their "advice". Now they receive equally hefty fees for dealing with tax disputes that arose on the basis of that "advice". The Nokia dispute represents only a small part of the staggering Rs 250,000 crore locked up in tax claims with the appellate tribunals and the law courts. These contingent claims total almost 2 percent of Indian GDP. Traditionally, up to 5 to 7 percent of the disputed amount goes in transaction costs, mainly to lawyers or chartered accountants. On Rs. 250,000 crore, that's about Rs. 15,000-20,000 crore that the lawyers make. No wonder the "learned friends" are laughing all the way to the bank.

Recall also the scope for enormous corruption by the revenue department. These are disputes over contingent claims on company cash flows, claims that are being shuffled around on pieces of paper. Their final resolution depends on nameless, faceless, government bureaucrats interpreting laws that are so convoluted, that interpretation is anybody's guess. Nani Palkhivala had called the Income Tax Act with its over 3,000 amendments an incomprehensible national disgrace. And this was in 1990. How comprehensible is it in 2014 ?

The VAT dispute is equally astonishing. Under a memorandum signed with Tamil Nadu, the state was to refund the 4 percent value added taxes paid by Nokia on phones sold in the domestic market. Apparently that has not happened. The Tamil Nadu government simply stopped refunding Nokia the amount it had contracted to refund. Why refund the money to them, when they're anyways on the way out, seems to be the reasoning here.

After all this, that slim little book which is the Vietnamese tax code must be quite appealing.

What about the Land ?

There is finally the minor issue of the land that the Nokia plant is located on. Nokia's factory sits on a huge chunk of land - 210 acres - in Sriperumbudur. Acquisition of land on the outskirts of India's cities by MNCs for manufacturing is a very lucrative proposition. Over a period of time, the city creeps up amoeba-like on the factory, hugely increasing its value. The value of the land alone far outweighs the initial investment over, say, a 20-year period, with the profits of the investment in the intervening years being the icing on the cake. In Sriperumbudur, land prices are up over 1,000 times in certain pockets over the past 20 years. Yes, that is 1,000 times!

Part of the reason - other than industrialisation - is that Chennai's second airport is supposed to come up there. The current airport at Meenambakkam faces saturation in the next decade. But for the tax cases, Nokia would certainly have recovered its initial investment just with the appreciation of the land value. Whether Nokia can realise it now is debatable, given the size of the claims by the government. Because of the tax cases, the title of the Nokia land essentially passed to the Kanchipuram tehsildar when the CBDT attached it. The company now only has an operating license to operate the facility. Land prices in Sriperumbudur would skyrocket when the airport is finally approved for the site. If Nokia essentially abandons the plant, - which looks likely - that's to the government's benefit as the land gets acquired free, and is set off against the tax claims. Of course, this makes the government's task of land acquisition for the airport much easier. Conspiracy theorists will have a field day thinking if this was the reason behind going after Nokia. Even if the conspiracy theorists are wrong, what this whole episode does to the country's reputation is another issue.

... and Exit

With all this dramabaazi there was no way the ownership of the Sriperumbudur facility could have been transferred to Microsoft when that company bought out Nokia worldwide. It was, therefore, left out of the Microsoft deal. This effectively limits Nokia's tax liability to the value of their assets in India. Nokia ran the plant as Microsoft's contract manufacturer for a year after the buy out was announced. Microsoft effectively then pulled the plug on the facility by ending the agreement. Presumably, all this was prearranged, and part of the adjustments necessary for the Microsoft purchase to go through.

Nokia will, in all probability, now abandon the plant after mothballing it for a respectable period. The tax claims on it are far larger than the value of the plant as a going concern. Despite the appreciation of land in Sriperumbudur, the tax claims are even larger than what an asset sale would realise. The fact that Bac Ninh is up and running, and close to peak capacity, means that Nokia has factored in no transfer of machinery and equipment from Sriperumbudur to Vietnam. This means no disruption in Nokia's global supply chain arrangements. It also means that the CBDTs asset freeze is meaningless from Nokia's standpoint. The government will then get back the land the plant sits on for free, presumably aiding it in its acquisition efforts for the airport. The integrators have also started shutting down. Of the vertical integrators, BYD has folded up, and Foxconn, Salcomp, and Perlos (now Lite-On Mobile) are on their way out.

The 8,000 full time jobs are now down to 1,000. These will disappear, as will the jobs with the integrators. The unions - CITU among them - will growl a little, but will have no choice other than to accept the situation. Besides, the cash infusions through Nokia's voluntary retirement scheme (VRS), at about Rs. 6 lakh per worker, will leave the local economy buoyant for some time. Indian consumers of the low-end feature phones will face a shortage initially, but Bac Ninh is already picking up the slack. (To read the main lessons from Nokia's exit, click here)

Adil Rustomjee is an investment adviser in Mumbai. Comments are welcome ata_ rustomjee@hotmail.com.

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Updated Date: Oct 16, 2014 14:52:56 IST