Countries whose firms continuously innovate, adopt new technologies and upgrade production are generally better positioned to diversify exports and compete in higher-value manufacturing. Yet innovation emerges from capabilities that firms accumulate over time. While merchandise trade deficits arise for many reasons, India’s persistent merchandise trade deficit also raises important questions about the capabilities that underpin industrial competitiveness. How do Indian firms compare with their counterparts in other economies in terms of product and process innovation, and the capabilities that make such innovation possible?
Innovation Reflects Deeper Capability Gaps
The latest World Bank Enterprise Survey shows that Indian firms lag well behind their counterparts in China and other lower-middle-income economies across multiple indicators of innovation. Only 3.9 percent of firms introduced a new product or service during the previous three years, compared with 20.9 percent among lower-middle-income economies and 32.7 percent in China. The challenge is particularly acute among firms employing between 5 and 19 workers, where the corresponding figure is just 3.6 percent, compared with 19.4 percent among lower-middle-income economies. Process innovation is similarly limited, with only 2.3 percent of Indian firms introducing a new production process during the previous three years, against 12.5 percent among lower-middle-income economies and 24.8 percent in China. The gap extends to research and development (R&D): only 0.5 percent of India’s medium and large firms reported R&D expenditure during the previous fiscal year, compared with 12.8 percent among lower-middle-income economies and 43.2 percent in China.
While firm-level innovation indicators do not determine national trade outcomes on their own, they provide an important window into the productive capabilities that shape long-term industrial competitiveness. Economies in which firms consistently invest in skills, management, technology and process improvement are generally better positioned to upgrade production, diversify exports and compete in increasingly sophisticated industries. The question, therefore, is not simply why innovation rates remain low, but whether firms possess the underlying capabilities that make innovation possible.
Building Capabilities Before Innovation
One of the clearest manifestations of India’s capability gap is workforce development. Only 2.9 percent of Indian firms offered formal worker training during the previous fiscal year, compared with 25.8 percent among lower-middle-income economies and 79.1 percent in China. The gap is particularly severe among smaller firms: just 1.1 percent of small firms in India provided formal training, compared with 20.4 percent among lower-middle-income economies and 73 percent in China. Even among medium-sized firms, the proportion was only 8.6 percent, well below the corresponding figures of 34.2 percent and 91.6 percent. Training enables firms to adopt new technologies, improve production processes and continuously upgrade products. The challenge, therefore, lies less in the intensity of training than in the very low incidence of firms investing in workforce development.
These capability gaps are not independent of one another; rather, they reinforce each other over time. Workforce development does more than equip employees with technical skills. It fosters continuous learning, knowledge sharing and incremental problem-solving on the shop floor, where many process improvements originate. Such investments also strengthen firms' absorptive capacity, that is, their ability to recognise, assimilate and apply new knowledge, enabling them to adopt new technologies and improve production more effectively.
Yet the incentives to invest in workforce capabilities often remain limited. The widespread use of temporary and contract labour in Indian manufacturing can reduce the expected returns to firm-sponsored training, as employers face greater uncertainty over retaining skilled workers, while workers themselves have weaker incentives to acquire firm-specific skills when employment relationships are short-lived. Over time, this constrains not only skill accumulation but also the organisational routines through which firms learn and innovate. Without sustained investments in human and organisational capabilities, firms are less likely to build the absorptive capacity needed to sustain innovation and productivity growth.
Capability deficits are equally evident in management, quality systems and technology adoption. Indian medium and large firms record an average management practices index of 39.8, compared with 48.6 among lower-middle-income economies and 60.4 in China. Similarly, only 4 percent of Indian firms possess an internationally recognised quality certification, compared with 8.8 percent among lower-middle-income economies and 16 percent in China. The gap is particularly pronounced among smaller firms: just 1.4 percent of small firms in India have an internationally recognised quality certification, compared with 5 percent among lower-middle-income economies and 7.9 percent in China. International quality certification reflects stronger production systems and quality management practices that facilitate participation in global value chains. Similarly, only 1.6 percent of Indian firms reported using technology licensed from foreign companies, compared with 3.1 percent among lower-middle-income economies and 12.4 percent in China. Together, these indicators point to a broader structural challenge: many Indian firms lack the capabilities needed to absorb technology, improve production and compete consistently in higher-value manufacturing.
Why Scale Matters
Firm size is an important part of this story. Many investments in worker training, quality certification, technology adoption and research and development become economically viable only once firms reach sufficient scale. Yet Indian manufacturing continues to exhibit a pronounced ‘missing middle’, with many small firms but relatively few medium-sized enterprises. Firms that remain small are less able to spread the fixed costs associated with capability building, making it more difficult to invest in skills, managerial systems, quality standards and technological upgrading. Scaling firms is therefore central to capability formation and sustained competitiveness.
The experience of East Asia illustrates the importance of these foundations. China’s rise from labour-intensive manufacturing to electronics, telecommunications equipment, batteries, renewable energy technologies and electric vehicles was accompanied by stronger capabilities that enabled innovation, industrial upgrading and export diversification. Firms first learned to absorb, adapt and improve existing technologies before becoming innovators in their own right. Innovation, industrial upgrading and export sophistication emerged from this broader process of capability accumulation.
From Capability Gaps to Trade Competitiveness
Countries with stronger firm capabilities are better able to move into technology-intensive industries and export increasingly sophisticated products. India, by contrast, remains concentrated in relatively low- and medium-value-added exports while continuing to import large volumes of technology-intensive goods, reflecting persistent gaps in domestic technological capabilities. This has created a structural imbalance in which merchandise exports have not upgraded sufficiently to offset rising imports of technology-intensive products, increasing reliance on services exports and capital inflows to finance external imbalances.
The policy challenge, therefore, extends beyond promoting innovation alone. It requires strengthening the ecosystem in which firms build capabilities, scale and compete. Recent Union Budgets have increasingly recognised these challenges through revised MSME classification thresholds, expanded credit guarantee support, cluster-based development initiatives, the Production Linked Incentive framework, the National Manufacturing Mission, and efforts to strengthen domestic capabilities in sectors such as semiconductors and electronics.
Building firm capabilities should become an explicit industrial policy objective rather than being treated solely as a by-product of innovation policy. Policies that support workforce training, managerial upgrading, quality certification, technology extension services, supplier development programmes and stronger linkages between MSMEs and larger firms can strengthen firms’ ability to absorb technology, upgrade production and compete in higher-value manufacturing. Ultimately, improving India’s trade competitiveness depends on building the capabilities that enable firms to innovate, scale and compete.