Why manufacturing matters

Discussion paper
George Campbell

This paper focuses on the importance of manufacturing industry, the rationale for a proactive governmental approach, and the policy agenda that needs to be developed to support a high growth strategy. The options for policy development canvassed here are not exhaustive. While some of the constraints to growth will be identified, and possible means to encourage manufacturing investment explored, more work and discussion with the manufacturing community is required. This is particularly the case in relation to investment in education and training, and the concern about the negative perception of manufacturing, which is beginning to be addressed by State governments, given the manufacturing policy vacuum at the Commonwealth level. These and other issues will be canvassed in future discussion papers and research projects as the ALP consultation process with the manufacturing community continues in 2002-03.

Part One: manufacturing & proactive policy

In Part One of this paper we focus on the importance of manufacturing and the rationale for a proactive policy approach. This section will discuss the characteristics of manufacturing industry that are unique, and provide the rationale for a proactive approach by government to encourage the development of high value-added, technology-intensive, export-orientated manufacturing.

Manufacturing & technical change

The contribution of the manufacturing sector to research and development (R&D) is disproportionately greater than its contribution to output. R&D is crucial for innovation, export growth and import substitution. It is also the key driver of the accumulation and exploitation of knowledge, which the OECD argues is the major driver of modern economic growth:

Today's rapid advances in science and technology mean that OECD economies are increasingly based on knowledge ... The ability to create, distribute and exploit knowledge and information seems ever more important and is often regarded as the single most important factor underlying economic growth and improvements in the quality of life. The competitiveness of firms depends crucially on how well they make use of their intangible assets such as skills and creativity and gain access to new ones by co-operating with other firms and universities. How well countries respond to these challenges depends on how well business, government and the labour force work together to exploit these key assets. It also depends on how well firms and government recognise this common challenge and respond, effectively, forcefully and coherently.1

In Australia in 1996-97, R&D expenditure by the manufacturing sector accounted for 59 per cent of private R&D investment.2 Over the course of the last decade, manufacturing has contributed over 50 per cent of total private R&D. The sector is clearly a driver of knowledge and innovation.3 World exports are increasingly knowledge intensive, and Australia's trade deficit in elaborately transformed manufactures (ETMs) is rapidly worsening.

In countries with a much larger share of manufacturing in GDP (USA, Germany and Japan), the manufacturing industry accounts for up to 80 per cent of private R&D expenditures. Furthermore, the overall share of business R&D in GDP is more than double that of Australia. The reason for the higher share of R&D as a proportion of GDP is not only the greater contribution of the manufacturing sector (and its disproportionate contribution to R&D), but the greater significance of manufacturing industries that are R&D intensive, such as pharmaceuticals, electronics and motor vehicles.

In addition, expenditure within manufacturing industries on training and hours of training per employee are above the average for Australian industries. This emphasises another contribution of the manufacturing sector to technical change, which is the diffusion of new and existing knowledge through vocational training.

Based on the OECD definition of innovation, it has been found that manufacturing industries have a particularly high propensity for innovative activity: "Manufacturing firms are three times more likely than other industries to engage in technological innovation and significantly more likely to engage in non-technical innovation."4

If Australia is to become a 'knowledge nation' we must encourage the development of industries that are significant contributors to innovation and technical change. Large parts of the manufacturing sector clearly fall into this category, and thus should be assisted. Furthermore, these manufacturing industries aid in the innovation and development of other industries, thereby emphasising the importance of developing the manufacturing sector.

Manufacturing & productivity growth

The greater an economy's productivity, the higher its growth in production and real incomes. Many sources, including the Productivity Commission, the Industry Commission and the Department of Industry, Tourism and Resources, have pointed out that the contribution of manufacturing to annual average productivity growth in the market sector has been greater than manufacturing's contribution to gross value added output.5 The high contribution of manufacturing is a function of the relatively high rate of productivity growth in manufacturing and the comparatively large share of GDP represented by this sector.

Advances in technology brought about by R&D and innovation have been a key factor in manufacturing productivity growth. Other contributors to the high levels of manufacturing productivity include the existence of increasing returns, both static and dynamic. Static returns (internal economies) relate to economies of scale and are common to large-scale industries, such as manufacturing, transport and storage industries, where the cost of production per unit falls as the production increases. Dynamic returns are brought about by positive externalities, such as economies of agglomeration, or 'learning by doing', whereby experience in production ensures that the production possibility frontier is reached, or whereby innovation is encouraged that pushes the production possibility frontier outwards.6 As output increases, the employment of more efficient capital-intensive production methods is facilitated. Growth in an industry's output also overcomes indivisibilities associated with sunk costs such as R&D. Hence, increasing returns caused by an increase in industry output leads to an increase in manufacturing productivity.7

Increasing returns is an industry characteristic almost unique to manufacturing. Increasing returns are especially significant in cluster development, and can help generate a self-reinforcing circle of growth that will increase the living standards of Australians.

The indirect contribution to productivity growth

The fact that a significant share of manufacturing output is not consumption goods, but capital goods and intermediate inputs for other industries, leads to positive externalities arising from the presence of a manufacturing sector. These manufacturing inputs embody continually improving technology that usually increases the efficiency and quality of the industries using these inputs.8 Thus, the presence of a high technology domestic manufacturing sector indirectly contributes to productivity growth in other parts of the manufacturing sector and other sectors of the economy. This represents a positive externality almost unique to the manufacturing sector.

Some argue, including the Coalition government, that it is not essential to design and produce high technology goods and services here, just as long as we consume them. This is grossly simplistic; while access to imported capital goods is essential, it is not enough. Within the capital and intermediate goods sectors, there is increasing evidence of the localised nature of learning and efficiency gains. This 'learning by using' encompasses the two-way flow of knowledge between users and producers of capital goods. A major source of the competitive advantage of manufacturers and users are these 'geographically localised' interactions; that is, localised feedback from customers and suppliers is an important way for manufacturers to improve their products and for their customers to improve the efficiency of their inputs.9 This process is usually most effective when the producer and consumer are 'geographically localised'. This is another positive externality generated by local high technology manufacturing. It is also an important feature of localised clusters.

The current account

In 2000-01 Australia had a trade deficit of $39.3 billion in manufactured products.10 In addition to the direct loss of employment, this trade deficit coupled with a high-income elasticity of demand for manufactured imports can pose a constraint to economic growth; that is, as incomes increase, consumption of imported goods will rise disproportionally, increasing our current account deficit. This will pressure the government to reduce import demand by slowing growth. This process is known as the balance of payment constraint to growth. If there were a significant improvement in the ability of the manufacturing sector to substitute for imports or generate exports, this balance of payments constraint to growth would be lessened.

The current structure of the Australian manufacturing sector worsens this problem. The output share of low and medium technology intensive manufacturing in total Australian manufacturing is well above the OECD average. Unfortunately, the fastest growing global sector of manufactured exports is high technology intensive manufacturing. Export growth in this area is growing at over twice the rate of low and medium-low technology intensive manufactured exports. Therefore, the current structure of Australian manufacturing inhibits export growth in manufacturing relative to the rest of the world. This issue is canvassed in further detail in Part Two of this paper, when constructing a high growth strategy for manufacturing is discussed.

Manufacturing & services

Many economic activities currently classified as services and supplied to the manufacturing sector were originally undertaken within manufacturing enterprises. The imperatives of greater division of labour and the ideology of outsourcing have changed this in the last 20 years.

Many of these service-based firms still remain heavily dependant upon demand from the manufacturing sector. There is great complementarity between the growth of manufacturing and high value-added services: "It is no accident that many of the countries with the largest share of world trade in manufactures also have a large share of world trade in services." 11 The computer industry provides the best example of the link between the manufacturing and services sectors. "Rapid improvements in the manufacturing capacity of micro-processors have greatly increased the computing power of these 'chips'. In turn, this feeds directly into the development of new programmes to exploit this enhanced processing power. This has led to the creation of new service industries such as, multi-media and mobile phone communications, which did not exist even 10-20 years ago.12

Associate Professor O'Connor makes the point that most service sector activity is in some part of the process of making things:

It (the service) may begin the process (with market research and industrial design), be involved with the messy stages of assembly (process engineers, material scientists, structural engineering), help again in marketing (advertising) and distribution (logistics) and have a say in the effect of the product (environmental management), or negotiate regulations about its sale or use (legal firms) ... Only where manufacturing has been nurtured will the service jobs appear.13

In his highly influential The Competitive Advantage of Nations, Michael Porter stated that the link between manufacturing and services is essential to the national competitive advantage of service industries.14 Two such links are the 'buyer/supplier relationship' and 'services tied to the sale of manufacturing goods'. The former link is the connection between a service and the buyer's value chain. As noted earlier, many service industries have been created out of the de-integration of service activities traditionally performed by manufacturing. Therefore, these service industries would be greatly endangered if the manufacturing industries they provide services to decline. The second feature of the buyer/supplier relationship is that the manufacturing sector can strongly influence the types and amounts of services demanded, as well as the sophistication of these services.

The second link between manufacturing and services occurs when the sale of a manufactured good creates a demand for an associated service. This may be software to run the manufactured goods, equipment servicing, insurance, training and consulting, etc. Without the sale of the manufactured good, these services would not be demanded. The export of manufactured goods can help the export of services around that good.

Hence, the explosion of the service sector is in part due to the growth and restructuring of the manufacturing sector. If the manufacturing sector was to falter, then the services sector would be greatly impacted.

There exists, alongside the traditional links between manufacturing and service industries, the potential for high growth industries centred on service-enhanced products. As emphasised by Richard Lester, Director of the Industrial Performance Center at MIT:

The high value added goods of the twenty-first century will be service enhanced products. Such products bring together manufacturing and services in ways that defy our conventional statistical categories. They bundle together in desirable combinations the capabilities of advanced manufacturing systems and new possibilities in design, customization, rapid delivery, and product quality and uniqueness - all enabled by information technologies.15

These products provide unique opportunities for the manufacturing sector and highlight the growing significance of cluster development. It is unlikely that a country will extensively develop high technology service industries without significant high technology manufacturing industries.

Linkages

Manufacturing has strong economic linkages or purchasing and supply relations with other industries. The manufacturing industry has the highest level of demand per unit of output for the goods and services of other domestic industries (intermediate inputs). The manufacturing sector is the sector most integrated with other parts of the Australian economy.16 That is, the manufacturing sector uses the outputs of the other sectors to produce their goods at a far greater ratio than any other sector of the Australian economy:

The economic significance of these closer linkages with other industries is that every dollar of manufacturing output generates more activity and jobs in the economy compared to a dollar increase in the output of other industries.17

Successive rounds of activity induced by an increased output from a particular industry are measured through multiplier analysis. Manufacturing industry has total multiplier effects 20 per cent and 25 per cent larger than that of agriculture and mining, respectively.18

However, this multiplier effect is reduced by high import penetration in manufacturing products. As a large share of inputs are sourced from overseas, the "... comparatively high import penetration in manufacturing products in Australia reduces the multiplier effect of manufacturing industry, as a large share of inputs are sourced from overseas."19

The dominant economic interdependence of manufacturing makes it a key sector in forming industrial clusters, which are essentially vertical or horizontally linked industries taking advantage of increasing returns, and knowledge and technical transfers. Manufacturing industries are already the most integrated of industries with the wider economy.

Why a proactive policy?

The strategic role of technology intensive manufacturing. The National Institute of Economic and Industry Research (National Economics) has identified several particularly important industries that are important because they lead to a net expansion in international trade.20 These are strategic industries that are technology intensive and produce complex, elaborately transformed products, which are skill, knowledge and innovation intensive. The strategic nature of these industries demands a proactive government approach to encourage these industries.

National Economics argues that these industries are strategic because:

(i) They have strong upstream and downstream linkages with other industries in the economy;
(ii) They are the industries which, in the main, transfer leading edge technologies to the local economy; and
(iii) They are the industries that develop the skills, work organisation arrangements and new management techniques which, through labour turnover, supply chain networks etc., spill over to the rest of the economy, thus transferring both technology and knowledge to other important industries - including technical service industries.21

The preceding parts of this paper demonstrate that the characteristics of technology intensive manufacturing fit these three criteria, and thus should be encouraged by a proactive government approach.

Externalities and co-ordination: The characteristics of the manufacturing sector that make it unique have been detailed. One of the most significant characteristics of manufacturing is the generation of positive externalities related to knowledge, innovation and productivity. Externalities are costs and benefits that cannot be internalised within the pricing decisions of individual firms. The market mechanism cannot satisfactorily value these externalities. This provides justification for government to actively identify these externalities, and encourage the development of industries that generate such positive externalities.

Linked to the failure of the market to internalise the costs and benefits of externalities is the phenomena of co-ordination failure, whereby firms fail to take into account the effects of their localisation decisions on other firms; that is, they fail to internalise the external effects they create.22 For example, if numerous firms producing the same good chose to operate in the same locality, this would provide large incentives for the development of upstream and downstream industries in that locality. These localisation decisions can generate clusters if co-ordinated effectively. Co-ordination of this industry is another justification for government to take a proactive approach.

Knowledge: The empirical evidence detailed above demonstrates the unique and disproportionate contribution manufacturing makes to knowledge and innovation. Many theories of economic development, for example cumulative causation theory and endogenous growth theory, stress the importance of knowledge and innovation. Clive Hamilton, for example, argues that:

... knowledge and know-how are more important in the modern economy than physical capital and raw labour power then, instead of sitting back and hoping that trade liberalisation will set off a growth process, governments should concentrate on promoting education, training, innovation and the ability of local firms to commercialise technologies. This is a broad strategy that is relevant to both developed and developing countries and avoids the zero-sum character of other approaches. Such a strategy demands not only investment in institutions that over time build and promote human capital, but regulatory systems that help to keep the benefits of knowledge and technological innovation at home.23

The contribution to knowledge and technical change by manufacturing and the importance of this to the wider economy provide a justification for the government to pursue a proactive approach and encourage greater development of manufacturing.

Removing the balance of payments constraint to growth: As discussed earlier, the massive trade deficit in manufacturing goods and the high elasticity of demand for imported goods poses a real speed limit to economic growth. Roy Green argues that the development of a high skill, high productivity manufacturing sector is the best supply side strategy to overcome the balance of payments constraint to growth, hence boosting long-term growth and jobs by replacing imports and increasing exports. 24 To assist the development of manufacturing to eradicate this constraint is another justification for a proactive approach by government.

Part Two: a policy agenda

In Part One we focused on the importance of manufacturing and the rationale for a proactive government approach. However, such theoretical arguments are in the main applicable to the manufacturing industry in most countries in the world economy. Yet each nation's manufacturing sector has its own unique history, industry and firm structure, as well as strengths and weaknesses. Accordingly the focus of an industry development strategy and the appropriate policy mix will inevitably vary from country to country, and even within regions.

In this part, we identify the need for a policy framework that helps Australian manufacturing achieve stronger growth. This is achievable in part by lifting the constraints to growth, such as under-investment in innovation, lack of export orientation and negative public perceptions of manufacturing. However, it is also suggested that a significant improvement in manufacturing growth is unlikely without a substantial and rapid shift in the composition of manufacturing value added to more knowledge and technology intensive activities.

Constructing a high growth strategy

Despite stronger growth since late 2001, Australian manufacturing has stagnated since the mid-1990s. Of 27 countries in the OECD, Australian manufacturing ranked near the bottom (20th) in terms of growth in production in the six years ending 2001.25 Not surprisingly, given this poor performance, Australian manufacturing’s share of total economic activity at the end of the 1990s (around 13.5 per cent) remained well below the OECD average of 19.3 per cent. Only Greece and Luxembourg had smaller manufacturing industries in relative terms. This also occurred over a period when the Australian economy was one of the highest growth economies in the OECD.

This stagnation in Australian manufacturing relates more to long term structural factors, although there were some cyclical influences at work. For example, despite strong domestic demand during the 1990s, the domestic market provided little in the way of a platform for stronger growth because:

Much of the increase in demand for manufactures in Australia came in traditional products where no capacity existed or where such capacity had been substantially rationalised (as in the case of demand for 4W Drive and micro/small cars in the auto industry).

Much of the increase in demand for 'new' manufacturing goods, particularly IT and factory automation technology also came in areas where Australia had little or no productive capacity.26

In terms of exports, some sectors did very well indeed. For example, Australia's car and auto components industry lifted exports from around $2 billion in the mid 1990s to $5 billion in 2001. However, the Asian crisis in the late 1990s reduced the trend growth of Australia's elaborately transformed manufactured exports (ETMs). The slowing of export growth over the 1995-2001 period is important given the shift in the export orientation of manufacturing. This is highlighted in Victorian manufacturing, where exports accounted for less than 20 per cent of the growth in real manufacturing turnover in the 1980s, but almost two thirds of the growth in manufacturing during the 1990s.27

This situation in Victoria is similar to Australian manufacturing nationally. Simply put, with little of the strong domestic demand translating into growth in manufacturing domestic market sales (outside of the less trade exposed sectors dependent on industries like housing and construction) any factors dampening export growth are likely to have a significant impact on the overall growth rate. Hence any long term strategy to lift manufacturing growth needs to focus on both domestic and export growth. As we will see, both these sources of growth are constrained by structural factors. In particular, the two issues discussed below being under-investment in innovation and under-development of Australian manufacturing's export orientation are good examples of how the constraints to higher growth are deeply embedded in the structure of activities that make up Australia's manufacturing industry.

The first of these issues relates to Australian manufacturing’s under-investment in innovation and reliance on medium and low tech manufacturing:

  • At the end of the 1990s Australia had a higher share of manufacturing R&D in medium low and low technology manufacturing (37 per cent) than virtually any other OECD country and three times the OECD average (12.3 per cent).
  • OECD data also shows that in the average OECD country manufacturing invests about 7 per cent of value added in R&D compared to less than 3.5 per cent in Australia. A broader measure of this is the OECD measure of expenditure on innovation, which is all expenditure related to scientific, technological, commercial, financial and organisational steps that are meant to lead to the implementation of technologically new or improved products and processes. The OECD average for manufacturing expenditure on innovation is 3.7 per cent of sales compared to 1.9 per cent in Australia. On this measure Australia ranked 16th out of 19 OECD countries in 1996 and is likely to have slipped further since then.

Australian manufacturing's under-investment in innovation and R&D and over reliance on medium and low tech manufacturing is a major constraint to higher growth and means 'catching up' is that much harder. If in both the OECD and Australia over the next decade R&D growth in manufacturing in high and medium high tech industries is 10 per cent per annum and medium and low tech industries 5 per cent per annum, then OECD R&D growth will be about 20 per cent more than Australia's.28 This reflects Australia's failure to shift the structure of its manufacturing industry to more knowledge and technology intensive activities.

At the end of the 1990s high and medium high technology based manufacturing industries accounted for around 9 per cent of total OECD value added. In Australia it was less than 6 per cent and Australia was near the bottom (22 out of 27) of the OECD ladder on this measure of the share of technology and knowledge intensive industries in total economic activity. An important factor explaining Australia's different industry structure is our traditional reliance on food and basic metal manufacture and the absence of an ICT manufacturing base. In the late 1990s Australia's share of ICT manufacturing in business sector value added was lower than any of the 21 OECD countries for which data was available. The share of ICT manufacturing in total manufacturing value added was also amongst the lowest in the OECD.29

The policy debate about correcting Australia's under-investment in innovation/R&D is as much about the appropriate R&D incentives and enhancing the capacity of manufacturing firms to innovate as it is about how to accelerate the shift to more value added knowledge intensive activities where Australian manufacturing is likely to attain more sustainable competitive advantages.

The second issue that reflects how structural factors are constraining manufacturing growth concerns the under-development of our manufacturing export sector. Despite strong manufacturing export growth over the decade to 1995, ETM exports still account for less than 25 per cent of Australia's total export income compared to the average for the APEC countries of almost two thirds. In addition, as suggested in table three below Australian manufacturing export growth during the 1990s wasn't that much better than the OECD average, largely because of the slow down post 1995. By the end of the 1990s high and medium high technology industries accounted for 65 per cent of OECD manufacturing exports. In Australia, they accounted for less than 40 per cent and Australia was near the bottom (24 out of 29) of the OECD ladder on this measure of the share of manufacturing export income from knowledge and technology intensive activities.30

Reinforcing the constraint to growth that is embedded in the composition of Australian manufacturing exports are additional factors that need to be taken into account in constructing a high growth strategy. For example:

  • Despite the surge in ETM exports over the past two decades Australian manufacturing's export share of turnover at the end of the 1990s (around 25 per cent in current prices) is still low compared to the U.K. (37 per cent), NZ (36 per cent), Finland (46 per cent), Denmark (58 per cent), Canada (50 per cent), and many other countries.31
  • A significant factor explaining Australia's lower export/output share is the under-development of our engineering industries an issue raised back in 1984 by the then Department of Trade. Amongst leading OECD economies the engineering industries are the heartland of the knowledge economy and ETM exports accounting for approximately 50 per cent of manufacturing exports with some 50 per cent of engineering output exported. Australia's engineering industries are less than 30 per cent of our manufacturing exports, and less than 25 per cent of Australian engineering industry production is exported.32

Additional constraints on the export orientation of Australian manufacturing include:

  • Less than 15 per cent of manufacturing businesses export and only half these export on a regular basis.
  • Australia has only a handful of 'born global' manufacturing exporters and very few firms doing more than $2 million per annum in exports ($2 million being the threshold used by the Mckinsey Consulting Firm to estimate the number of 'emerging exporters').
  • The low level of venture capital committed to start up and early stage manufacturers and the under-investment in innovation (particularly since 1995) also suggests that there isn't a large pipeline of rapidly expanding new manufacturing firms that could contribute significantly to higher growth outcomes for manufacturing.
  • Finally, industry and trade development initiatives since the mid 1990s have in aggregate not provided the stimulus to manufacturing exports that they did in the previous decade.

The policy debate about strengthening manufacturing exports is as much about the appropriate incentives and initiatives to improve the export capability of firms, as it is about how to accelerate the shift to more value added knowledge intensive activities - where Australian manufacturing is likely to attain more sustainable competitive advantages. Unfortunately, these issues are often ignored in the policy debate that overwhelmingly focuses on market access issues.

A high-growth policy agenda

Under-investment in innovation and the under-development of Australia's manufacturing export sector are not the only constraints to growth. There are other constraints, including the negative perception people have of manufacturing (old economy, smokestack, dirty repetitive, boring manual labour, etc.) which, by discouraging young people and highly skilled technical workers from seeking a career in manufacturing.33

The point of focusing on innovation and exports is to highlight the fact that simply stimulating R&D growth and exports across the board is unlikely by itself to significantly and rapidly increase the share of manufacturing value-added in more knowledge and technologically intensive manufacturing activities. Thus, in constructing a policy agenda to support a high growth strategy for Australian manufacturing, we must focus on two key issues:

1) The design of policies that can help overcome the constraints to growth (innovation, exports, perceptions, etc.). This includes initiatives to improve the environment for growth, as well as enhancing the capabilities of firms (R&D capability, export management capability, product design and process innovation capability, etc.) to realise growth opportunities.

2) Develop a strategy and the appropriate policy mix for accelerating the pace at which Australian manufacturing shifts value added to higher growth knowledge intensive industries and to higher growth value added products in a range of industries whatever their growth prospects.

These two issues will be central to the ALP as we develop a policy agenda for manufacturing. The remainder of this paper briefly identifies key questions associated with this policy focus as well as a few other key issues. The ALP wishes to engage the manufacturing community in a dialogue about these issues leading to the construction of a policy agenda to support a high growth strategy in manufacturing.

Policy options

A recent report commissioned by Victoria's Manufacturing Industry Consultative Council (MICC) focused on the following dilemma:

Under a 'business as usual' scenario Victorian manufacturing faces a number of constraints that are likely to restrict growth in production to no more than 2 per cent per annum over the 2000-15 period. What would be required to overcome these constraints so that trend growth averaged 3 per cent or more per annum instead of 2 per cent and what would be the benefits?34

As might be expected, the major factor required for lifting Victorian manufacturing’s trend growth rate by a third was identified as being additional investment in R&D and innovation and additional physical investment in plant, equipment and factories. To achieve this, Victoria's manufacturing R&D to value added ratio is required to rise from 3.5 per cent to 7.4 per cent over the 2000-15 period and substantially increased physical investment (over the base case), particularly through the attraction of more foreign direct investment in higher value adding manufacturing activities.

Not surprisingly, this and many other studies suggest that additional investment is the key driver to achieve and sustain a high growth manufacturing sector. From a policy perspective the issue is how to attract additional investment and how best to incorporate an investment attraction strategy within the overall policy agenda for manufacturing. In addition consideration needs to be given of ways to ensure that a sufficient proportion of this additional investment comes in more knowledge and technology intensive activities where competitive advantages can be sustained.

The options currently under consideration for investment attraction strategies include, but are not limited to the following:

1) For encouraging higher levels of investment in R&D the ALP's 2001 election program was committed to providing additional support to collaborative R&D initiatives between the public and private sectors. The ALP's 1998 election program was committed to providing greater R&D support to firms and industries with higher R&D intensities. Both these approaches would have provided more support to high and medium high technology based manufacturers, as well as more knowledge intensive firms in other industries.

In going forward, the merits of these past approaches are under review. There is also a strong view from industry that the existing R&D tax and grants system has become overly complex, less transparent, and provides less incentive and certainty than required to significantly lift the R&D and value-added ratio's in manufacturing and other industries.

One of several alternative options being considered (as an addition rather than in place of the existing system) to lift manufacturing R&D investment is a focus on incentives for building and strengthing the capability of firms to undertake R&D, as opposed to simply providing an incentive for the $ value of R&D undertaken (R&D capacity). Such an option in the short term could be trialled by State governments, with the possibility of a joint Commonwealth-State program being examined following evaluation of pilot programs. Experience in Ireland suggests that we should be focusing on R&D capability. This is linked to the development of clusters and the need to encourage specific industries that produce the most externalities. The government should consider funding up front R&D infrastructure and obtaining key researchers. This allows greater strategic planning, and capacity should follow the development of R&D capability, rather than vice versa.

However, in examining these and other options for increasing investment in R&D there are three threshold matters that require discussion including:

a) The magnitude of Australian manufacturing's under-investment in R&D relative to OECD benchmarks and the requirements of sustaining a high growth strategy (more than $2 billion per annum in today's dollars) require changes so large that no one program by itself is likely to achieve more than incremental changesin the short to medium term. Accordingly, the focus must be on the total policy package, the linkages and synergies between initiatives led by the private sector and those provided by the public sector, and an agreed timetable and milestones for charting progress.

b) Without successful strategies for commercialising R&D in Australia there is little benefit in seeking a step function increase in manufacturing R&D.

c) While the total policy package for encouraging manufacturing R&D needs to maintain an incentive structure to encourage all activities, the emphasis needs to be on initiatives to encourage more knowledge intensive/value-adding activities. How this is achieved is a matter requiring detailed discussions.

2) Increasing physical investment in plant, equipment and factories is more likely than other forms of investment to be influenced by the level of economic growth and the overall environment (or 'investment climate'). In some manufacturing industries, such as automotive and pharmaceuticals, governments will be required to maintain industry specific investment incentives to bothg sustain existing capacity and attract new capacity in a very competitive global environment.

Options being considered for influencing the level and composition of manufacturing investment are mainly to do with approaches to improve the environment for investment, as well as identifying specific deficiencies or gaps in areas such as infrastructure provision. The ALP is already engaging the manufacturing community in discussions on these issues. However, more detailed discussion is required on a different set of issues concerning:

a) Approaches to attracting foreign direct investment in new manufacturing capacity, particularly in high value, knowledge based activities. Unfortunately the Blackburn Report on this issue focused solely on process and institutional issues with little or no regard as to how best to target FDI for manufacturing. The government's Budget response appears equally ambiguous.

b) Developing a program based on supply chain analysis and relationships to identify constraints to investment in key value adding knowledge intensive activities as well as capacity and capability gaps or weaknesses that require new investment to strengthen the supply chain.

c) New approaches for attracting manufacturing investment to regional Australia, particularly in high unemployment rural and regional centres.

3) Mention has already been made of the desirability of encouraging manufacturing firms to undertake appropriate investments, which build or strengthen the organisational capabilities and management systems that can help firms enhance their growth potential. Such capability upgrades can relate to a wide range of functions, from R&D or export planning, to the capacity of firms to make use of the on-line economy or advanced manufacturing technologies.

In the past AusIndustry/NIES programs or subsidised consultancies have been the main policy levers for encouraging the building of better businesses through capability enhancing initiatives. Other programs such as export market development grants (EMDG) have been shown to encourage capability enhancing investments by firms.

What is now under consideration is a policy focus on capability enhancing initiatives for manufacturing firms with good prospects for growing the business by winning international business opportunities (through export or import replacement). A wide range of options is under consideration, ranging from R&D initiatives mentioned earlier, to 'export manager for hire' programs that would assist SMEs develop their export market development capability. The key area for further discussion is to identify priorities for capability enhancement, approaches to implementing appropriate programs (by industry sector, supply chain networks or other means), and the scope that exists in program development and delivery in partnerships between the government and manufacturing organisations (employer associations, unions, educational and research institutions, etc.), as well as partnerships between the Commonwealth and the States.

Increasing venture capital

A successful high growth strategy for manufacturing has to get the right balance between what needs to be achieved by established businesses, and what needs to be achieved by newly emerging businesses. Arguably, one of the weaknesses of Australia's industry policy debate has been the focus on 'old versus new industries' rather than the contribution from established and emerging businesses and the supply chains that link them.

For both established firms and start-ups, private equity finance and the managerial expertise that comes with it is an important factor for a successful high growth strategy. In Australia's case, the private equity manager base and available funds for expansion deals, turnarounds, and management buy-outs/buy-ins appears to be adequate for established firms in manufacturing and other industries. For newly emerging firms, however, the venture capital manager base and funds for seed, start-up and early expansion deals is seriously deficient, and a significant constraint to growth.

The most recent data benchmarking Australia's under-investment in venture capital (2000)suggested Australia was investing 0.12 per cent of GDP in 'classic' or institutional venture capital, compared to a 24 country average of 0.23 per cent of GDP.35 Somewhat different estimates prepared by the Superannuation Trust of Australia (STA) suggest that, for the year 2001, and using 0.2 per cent of GDP as the benchmark, Australia should have been investing around $1.3 billion in venture capital compared to actual investment of less than $400 million, with less than 10 per cent of this going to manufacturing. This may suggest that institutional venture capital investment in Australian manufacturing is 25 per cent or less of the OECD average. When combined with R&D investment that is half the OECD average, Australian manufacturing is clearly confronting a significant constraint to growth - particularly the contribution coming from newly emerging manufacturing firms that are knowledge and technology intensive.

The significance of this under-investment in venture capital should not be under-estimated. As noted in a recent report:

Importantly, the private equity infrastructure at the seed, start up and early expansion stages brings with it a network of linkages to the R&D infrastructure, and a pool of managerial expertise for early stage businesses that are technology and knowledge intensive. The development of such an infrastructure is a strategic competitive advantage in today's global economy.

Those that have such an infrastructure attract more R&D, additional venture capital, a wider pool of managerial expertise for start-up businesses as well as additional foreign direct investment. Increasingly, the development and exploitation of new intellectual property also becomes centred around the nations, states and regions where the private equity infrastructure is growing and the venture capital base has established the network of linkages between the R&D infrastructure and the organisations that make commercialisation happen. Those that do not have world class private equity infrastructure realise fewer of the benefits that come from this cumulative process of additional wealth creation.36

In examining how the venture capital constraint to growth can be overcome, the following options are being considered:

a) The Investment Innovation Fund (IIF) program initiated by the Commonwealth is regarded by many as an effective vehicle for growing the manager base and accelerating deal flow for venture capital. Nine IIF programs have been established with more than $350 million for investment (two thirds government, and one third private sector). In additional four pre seed funds will have more than $100 million to invest. However, to date, only one of the nine IIF programs (Nanyang) has a business plan aiming to invest more than 40 per cent of its fund in manufacturing, and less than 10-15 per cent of investments made by IIF managers have gone to manufacturing.

One option for addressing this situation would be to have a round of IIF funding to seed two or three managers focused on manufacturing opportunities. It may be possible to do this by the Commonwealth alone or in a partnership approach with the States.

An alternative option would be to encourage a 'Fund of Funds' vehicle with a focus on manufacturing in general and early stage manufacturing in particular. However, given the under-developed manager base for early stage manufacturing deal flow, such an approach may need to be combined with a IIF program focused on manufacturing.

A third approach would allow the venture capital manager base to grow on its own accord and hope that, by creating the appropriate tax-regulatory regime, sufficient quantities of overseas pension and endowment funds flow into Australia and 'spill over' into early stage manufacturing investment. This could be supplemented by encouraging corporate involvement in the venture capital market (as per Wesfarmers, Hewlett Packard, etc.) with encouragement for those firms prepared to focus on early stage manufacturing deal flow. What exactly constitutes 'encouragement' in this approach warrants further consideration. This might be supplemented by initiatives that would encourage the existing Fund of Funds managers (Wiltshire, DAF, Quay, Macquarie, ING, etc.) to support first time venture capital funds with a strong focus on early stage manufacturing deal flow.

b) Besides the 'classic', formal or institutional market for venture capital, significant funds (albeit in small investments) are available from 'angel investors', or high wealth individuals. On some estimates Australia has very high levels of angel investment relative to the institutional market. Thus, a strategy to harness such investment and encourage more of such funds flowing into early stage manufacturing may warrant consideration. Options for doing this might include:

  • Encouraging associations providing matching services between angel investors and firms looking for investors to enhance their efforts, particularly for early stage manufacturing investments.
  • Providing better linkages and communications between angel investors and the formal private equity market, as well as assisting more manufacturing SME's to become venture capital ready.
  • Examining the tax treatment of early stage investments in manufacturing and other designated industries.
  • Assign strategic investment advisors the role of connecting and co-ordinating angel investors and manufacturing companies in need of seed funding.

These and other approaches warrant further examination and discussion if the venture capital constraint to manufacturing growth is to be overcome.

In addition to these two policy areas, there are several other issues that government can address in order to encourage high growth manufacturing.

Clusters

Manufacturing generates increasing returns to scale, learning by doing and large technology transfers along the production chain. Manufacturing industries are also the most interlinked sector of the economy. This means that manufacturing industry is the best suited to generate clusters. These clusters can take the form of horizontal or vertical industry integration that takes advantage of increasing returns and the transfer of knowledge. The development of clusters can improve Australia's competitive advantage. Clusters can also generate and accelerate a virtuous circle of cumulative causation that increases the income and working conditions of Australians.

There is also a great need to develop linkages between specialised tertiary institutions; for example, ones specialising in engineering, with technology parks and the industrial parks. The development of regional clusters of this type should assist in the generation of ideas, the commercialisation of these ideas, and the development of skills. A discernable chain or cluster is essential with all three sectors becoming interdependent and providing feedback on the performance and areas of potential improvement.

The government should identify emerging clusters, aid in their formation and assist, where appropriate, existing clusters. The location, size and nature of an industry do matter, and the government must address these issues. As noted earlier, examination of clusters and supply chains can help focus on both the gaps in productive capacity, and help form the agenda for government or self-help initiatives to upgrade firm capabilities.

Maintaining domestic demand

In his 2000 evaluation of the 1992 McKinsey AMC report, George Argyrous found that the key factor for the success of emerging manufacturing exporters was the level of domestic demand. High levels of domestic demand using cumulative causation theory allow the mass production of consumption goods along the 'high-road' developmental model. That is, for manufacturing exporters, levels of domestic demand are an important factor affecting their viability: "...it is the result of the fact that economies of scale are only realised over time through an evolutionary process involving investment in ever-more specialized equipment as longer production runs begin to justify it. The idea, propounded by the McKinsey report, that exporting can occur in a short period of time after start-up completely ignores the limitations arising from this evolutionary process."37

Successful exporters who emphasised the importance of local economies of demand mostly manufactured consumer or mass intermediate goods. This refutes the claim homogenous consumer goods can only be successfully produced on the basis of 'low road factors'. We believe this analysis overstates the point. It is important for Australia to generate an increasing number of globally born exporters. However, the fact remains that domestic demand remains a key factor underpinning the growth of exports and needs to be factored into government policy.

To encourage manufacturing growth, the government should undertake demand management policies designed to ensure that exporters have a suitable base of domestic demand on which their export efforts can take place.

Government purchasing

Government spending has traditionally been a powerful source of market growth, especially in relation to industries with economies of scale. It has been especially influential in purchasing mass-produced, homogenous goods.38

The current economic rationalist policies of the federal government have impacted upon this feature: "While such policies appear to increase efficiency in the static neoclassical sense, they may not be efficient in the dynamic Schumpetarian, evolutionary sense. That is, by fragmenting government purchasing power the incentive to reach economies of scale by suppliers is also shredded."39 This has reduced the ability of manufacturers to access economies of scale and increasing returns, thereby negatively impacting on their competitiveness.

George Argyrous's study into emerging exporters found a causal link between public investment and private productivity and profitability. The government, by acting as a key customer for manufacturers of specialized equipment, sustains the crucial layer of capital goods firms that play a pivotal role in the diffusion of technology:

...The spill-over effects that arise when firms adapt for the private sector products initially developed for government purchase raise overall productivity levels. This translates into rising real incomes, which expand the domestic market for consumer goods, which then induces further investment, and so on in a cumulative way.40

More is being done at a State level on government purchasing and the encouragement of local content due to the policy vacuum at the national level. In addition to the Industrial Supplies Offices, both the Victorian and Queensland governments have put in place systems to increase local content in commercially sensible ways. The Victorian Industry Participation Policy is a good example of this. The Queensland government has also had significant success in increasing the local content; for example, the new Comalco Alumina Refinery at Gladstone will have a local content of nearly 80 per cent.

Hence, there is a powerful argument for the centralisation of government purchasing with some strategic planning about how to assist the development of key industries.

Sectoral policies

Industry policy over the last ten years has been characterised by the refutation of sectoral policies and a myopic focus on micro-economic reform and some encouragement of R&D. However, this paper has shown that the specific characteristics of manufacturing produce positive externalities and increasing returns to scale, best harnessed and developed through clusters. This gives scope for the re-introduction of sectoral policies aimed at assisting the formation and growth of these clusters. Policies to boost the general competitiveness of firms and sectoral policies are not necessarily incompatible. In fact, they are capable of reinforcing one another.

Roy Green sees considerable scope for the development of sectoral policies:

The potential role of sector strategies is highlighted by the spread of networking and customer-supplier linkages among smaller but more interdependent units of production and the scope for extending and building upon enterprise bargaining. However, this approach will require new structures to facilitate the development of strategies for each sector by unions and employers, and mechanisms through which the goals and vision of the participants can be translated into reality at the workplace.41

The federal government should, in consultation with manufacturing unions and industry groups, construct sectoral policies that are not industry welfare but effective tools to harness the unique advantages of industry clusters.

Policy agencies

A successful high growth strategy for manufacturing requires efficient and effective agencies for developing and implementing policy.

Since the mid 1990s, the ALP has argued that the agencies responsible for industry development policy have been undermined by funding cuts and the downgrading of their capacity to provide advice and policy options to government. In 1998 the ALP argued that the Productivity Commission should be abolished and a National Development Authority established. In 2001 it was agreed that the Productivity Commission would remain, but a significant part of its budget would be redistributed to new or existing agencies to strengthen and diversify the advice provided to government. In both 1998 and 2001 the ALP supported the re-establishment of a tripartite Manufacturing Council.

The question is where do we go from here? On the one hand, we could look at strengthening the existing Industry Department, establishing a mechanism similar to the Bureau of Industry Economics (BIE) and re-establishing a tripartite Manufacturing Council, with its own secretariat at arms length from the existing departments and agencies. Such a structure would be similar to what existed during the 1985-95 period.

There are a number of alternatives currently being examined, including:

a) The formation of a National Development Authority.

b) The establishment of an Office or Ministry of Manufacturing or something similar and distinctive to sharpen the focus on this key industry.

c) The formation of a Manufacturing Council along the lines of Victoria's MICC or Queensland's Manufacturing Leaders Group, where such a vehicle could be serviced either within the existing department structure or by an independent secretariat.

The ALP would value discussion of this issue, particularly on how and where to attract high-powered staff with a wealth of experience in formulating strategy and policies for manufacturing; and how to get representation from within the manufacturing community with the capacity to make a substantial commitment of time and resources to the development and implementation of the policy agenda. Attention also needs to be given to mechanisms to provide a more integrated industry-trade development strategy and the required synergies with the portfolios dealing with such matters as regional development infrastructure and education and training.

Conclusion

This paper has focused on the importance of manufacturing industry, the rationale for a proactive approach by government, and the policy agenda that needs to be developed to support a high growth strategy. The options canvassed for policy development are not exhaustive. While some of the constraints to growth have been identified and possible means to encourage manufacturing investment explored, more work and discussion with the manufacturing community is required. This is particularly the case in relation to issues regarding investment in education and training, and the concern about the negative perception of manufacturing that is beginning to be addressed by State governments given the manufacturing policy vacuum at the Commonwealth level. These and other issues will be canvassed in future discussion papers and research projects that will be undertaken as the ALP consultation process with the manufacturing community continues in 2002-03.


George Campbell is a Senator for New South Wales in the Australian Parliament and the Labor Shadow Parliamentary Secretary for Manufacturing Industry.


Notes

1. OECD, "Benchmarking Knowledge Based Economies", 1999, p. 7.

2. Australian Bureau of Statistics, "Research and Experimental Development-All Sector Summary 1996-1997", ABS 8112.0, 1998.

3. For example, Australian Business Foundation Limited, "The High Road or the Low Road? Alternatives for Australia's Future", Sydney, 1997, p. 201.

4. Toner, P., "Manufacturing Industry in the Australian Economy: Its Role and Significance", Journal of Australian Political Economy, No.45, June 2000, p. 24.

5. For example, Department of Industry, Tourism and Resources, "Industry Brief - Manufacturing Sector", December 2001, p.9 and Industry Commission, "Assessing Australia's Productivity Performance", Staff Information Paper, Table 5.3, p.50, September 1997.

6. Toner, P., "Main Currents in Cumulative Causation", Macmillan Press Ltd, 1999, p.12

7. Bureau of Industry Economics, "Productivity Growth in Australian Manufacturing Industry", Information Bulletin No.8, AGPS, Canberra.

8. This phenomenon is referred to as Verdoorn's law, which states that a 1 per cent increase in manufacturing output will cause approximately a 0.5 per cent increase in manufacturing productivity. See Toner for further details.

9. Toner, (2000), op.cit., p. 24.

10. Ibid.

11. Australian Bureau of Statistics, "8225.0-Manufacturing", March 2002, Table 4.3, p. 109.

12. Toner, op.cit., p. 26.

13. Ibid., p.37.

14. O'Connor, K., "Manufacturing still mattersÂ…even in the service economy", CEDA Bulletin, October 1999, p. 7.

15. Porter, M., The Competitive Advantage of Nations, The Free Press, New York, 1990, p. 252.

16. Berger, S. & Lester, R., "Made by Hong Kong", Oxford University Press, 1997, p. 30.

17. Industry Commission, "The Changing of Australian Manufacturing", Staff Information Paper, December 1996, Table 2.3.

18. Toner, op.cit., p. 39.

19. Ibid.

20. Ibid., p. 40.

21. National Institute of Economic and Industry Research, "Industry Assistance Reductions and the Australian Economy: Contemporary Issues and Future Prospects", 2000, p. 9.

22. Ibid.

23. Venables, A.J., "Localization of Industry and Trade Performance", Oxford Review of Economic Policy, Vol.12, No.3 Autumn 1996, p. 60.

24. Hamilton, C., "The Case for Fair Trade", Journal of Australian Political Economy, No.48 December 2001.

25. Green, R., "Industry Policy: Conflict and Consensus", Working Paper Series, Employment Studies Centre, University of Newcastle, February 1998, p. 5.

26. Derived from OECD Main Economic Indicators, April 2002.

27. "Rebuilding Australia: Manufacturing in the New Economy", p. 38.

28. National Institute of Economic and Industry Research, "Growth or Stagnation: Constructing an alternative scenario for Victorian Manufacturing in the New Millennium", p. 33.

29. OECD, "Science, Technology and Industry Scoreboard 2001", p.155. 1991 for the OECD is an estimate based on individual country data.

30. Ibid.

31. Ibid.

32. OECD STANS database and NIEIR database.

33. National Institute of Economic and Industry Research, "Growth or Stagnation: Constructing an Alternative Scenario for Victorian Manufacturing in the New Millennium", Chapter 4.

34. The tripartite Manufacturing Industry Consultative Council in Victoria and the tripartite manufacturing Leaders Group in Queensland have both put this 'perceptions' issue near the top of their list of the constraints that must be overcome if Australian manufacturing is to achieve stronger economic growth.

35. National Institute of Economic and Industry Research, "Growth or Stagnation: Constructing an alternative scenario for Victorian Manufacturing in the New Millennium", p. 91-109.

36. K. Hindle and S. Rushmore, "Global Entrepreneurship Monitor: Yellow Pages GEM Australia 2001", p. 11.

37. STA-IFS, "Stimulating Venture Capital Investment in Queensland Manufacturing", November 2001.

38. Argyrous, G, "The High Road and the Low Road to International Trade: Emerging Exporters Revisited", Journal of Australian Political Economy, No.45, p.59.

39. Ibid., p. 63.

40. Ibid.

41. Ibid., p. 64.

42. Green, R., "How Manufacturing Can Young People To Get High Wage Jobs", Working Paper Series, Employment Studies Centre University of Newcastle, October 1995, p. 15.

See also:

The boundaryless cluster: Information, communications & Ireland, by Roy Green, James Cunningham, Imelda Giblin, Mike Maroney & Leo Smyth.