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Air-conditioning & Refrigeration Industry Pre - Budget Memorandum 2003-04:

Air-conditioning & Refrigeration Industry Pre - Budget Memorandum 2003-04 RAMA 13 December 2002, New Delhi

SUMMARY OF KEY MESSAGES- AIR-CONDITIONERS, 1:

1 SUMMARY OF KEY MESSAGES- AIR-CONDITIONERS, 1 The Indian AC market size is Rs 2,790 crore comprising the household and commercial segments. The market is currently at a nascent stage and shows tremendous promise to grow. However, despite the reasonable growth in the last few years, the growth potential has not been entirely captured. The key bottleneck to growth is the low affordability of ACs. This is clearly evidenced in the Chinese market where substantially low price points (less than 50% of Indian retail prices) have driven penetration of ACs. In order to capture the growth potential, a substantial reduction in price is required. The primary cause for the high prices is the high incidence of indirect taxes, excise duties and import duties on the product category : accounting for close to 45% of the MRP. In particular, the abnormally high excise duty of 32% is a major deterrent to growth. With government support in duty and tax rationalization, the AC market can grow very rapidly over the next 5 years to as much as Rs. 14,000 crores by 2007. Reducing excise duties, indirect taxes and import duties is a win-win-win solution for the government, players and consumers. The specific short term proposals include: A reduction in excise duty from 32% to 16% with 40% abatement beginning March ‘03 Excise exemption in certain states such as Jammu, North East to be repealed as they destroy value for government, players and consumers and confer none of the intended benefits to the system A reduction of import duty to 25% for finished goods and 15% for components beginning Mar-03

SUMMARY OF KEY MESSAGES - COLD CHAIN, 2:

2 SUMMARY OF KEY MESSAGES - COLD CHAIN, 2 Agriculture has been recognised by government as a focus area Cold chains (84.18) are a vital part of the agricultural chain There is a huge unrealised potential for Preserving food and dairy products Improving food distribution Reducing cost of food to the common man Cold chain enjoy excise exemption. however , CENVAT credit on inputs is not available To maintain the spirit of exemption from incidence of taxes, replace exemption to cold chain by refund/ subsidy

THE INDIAN AIR-CONDITIONING INDUSTRY IS A Rs 2,790 CRORE MARKET:

3 THE INDIAN AIR-CONDITIONING INDUSTRY IS A Rs 2,790 CRORE MARKET Source: Francis Kanoi; Industry estimates Segment Value Volume Applications 1 Window ACs Rs 1200 crore 540k nos Homes, SOHO 2 Mini Split ACs Rs 730 crore 220k nos Homes, offices, shops, showrooms 3 Ducted Split and Packaged AC Rs 400 crore 216k tons Commercial establishments 4 Chillers and Central Plant Rs 460 crore 272k tons Industrial, institutional and large commercial Rs 2,790 crore Major players Amtrex Hitachi Blue Star Carrier Aircon Daikan Shriram LG Samsung Voltas Whirlpool O’General Matsushita Industry investment in line with potential resulting in surplus capacity leading to oversupply and price wars

THE RESIDENTIAL SEGMENT IS FAST OVERTAKING THE COMMERCIAL SEGMENT IN RAC WHILE THE PACKAGED AC HAS WITNESSED LIVELY GROWTH IN RECENT PAST:

4 THE RESIDENTIAL SEGMENT IS FAST OVERTAKING THE COMMERCIAL SEGMENT IN RAC WHILE THE PACKAGED AC HAS WITNESSED LIVELY GROWTH IN RECENT PAST Source: Francis Kanoi; Industry estimates Increasing share of domestic segment in RAC Growth of residential segment driven by higher affordability and disposable income, changing lifestyle in perceiving AC as need rather than luxury Residential segment expected to drive growth of RAC & eventually will increase share >80% as in the most markets Packaged AC displays, thrice the growth of GDP ‘000 Tons Estimates Actual Commercial Residential 14% Easy Availability of comprehensive range of ducted splits and ductless flexible PAC system & improved affordability will drive future growth on the back of high growth in IT, healthcare, retail, telecom, financial services, entertainment, leisure & tourism and other services sectors.

TREMENDOUS POTENTIAL FOR HOUSEHOLD AIR CONDITIONER MARKET TO GROW, GIVEN LOW PENETRATION:

5 TREMENDOUS POTENTIAL FOR HOUSEHOLD AIR CONDITIONER MARKET TO GROW, GIVEN LOW PENETRATION Very low penetration Leading to huge untapped potential of 83 mn* Per cent of all households Million Taiwan Hong Kong Korea Malaysia Thailand China Indonesia India 38 144 182 0.1 1.7 180 3 61 5 28 83 Total HH HH with refrigerators Untapped potential Unelect-rified Below poverty line Untapped potential Small towns and Rural Urban 1.8 144 36 64 33 55 28 Multiple ownership Source: Francis Kanoi; NCAER *After removing households below poverty line and in uncertified areas +

HOWEVER GROWTH IS LOWER THAN POTENTIAL AS AC IS VERY EXPENSIVE PURCHASE EVEN FOR HIGH INCOME CLASS (1/2):

6 HOWEVER GROWTH IS LOWER THAN POTENTIAL AS AC IS VERY EXPENSIVE PURCHASE EVEN FOR HIGH INCOME CLASS (1/2) Price income multiple for ACs in China** Income class P/I multiple Penetration Per cent of all HH Bottom 40% Next 20% Next 20% Next 10% Top 10% Sizable population in India finds ACs expensive Income class Penetration Price/ Monthly income multiple Untapped potential* Up to 12,000 12,000 – 16,000 > 16,000 @ price of Rs.21,000 # HH mn Per cent * After removing households below poverty line and in unelectrified areas ** Based on Urban population *** Monthly household income Source: Francis Kanoi; IMRB; NCAER MHI***

HOWEVER GROWTH IS LOWER THAN POTENTIAL AS AC IS VERY EXPENSIVE PURCHASE EVEN FOR HIGH INCOME CLASS (2/2):

7 HOWEVER GROWTH IS LOWER THAN POTENTIAL AS AC IS VERY EXPENSIVE PURCHASE EVEN FOR HIGH INCOME CLASS (2/2) Source: Francis Kanoi, ORG-GFK Growth has been lively in household air conditioner market but less than potential Value Rs. Crores Volume ‘000 units 1995 1998 2000 2001 2002 25% 9% 31% 30% 1995 1998 2000 2001 2002 18% 17% 26% 31%

THE HUGE DIFFERENCE IN RETAIL PRICES BETWEEN INDIAN AND CHINESE ACs EXPLAINS THE LOW PENETRATION, DEMAND:

8 THE HUGE DIFFERENCE IN RETAIL PRICES BETWEEN INDIAN AND CHINESE ACs EXPLAINS THE LOW PENETRATION, DEMAND Chinese retail prices are more than 60% lower than Indian retail prices Type of AC Indian price Chinese price US$ US$ 1 Ton window 360 136 1.5 Ton window 420 185 1 Ton split 555 199 1.5 Ton split 635 280 This explains difference between Indian and Chinese statistics Domestic market India : 0.3 mn units China : 14 mn units Penetration India : 1% China : 20% GDP RAC’s contribution to GDP in China is 4 times that of India Exports India : Insignificant China : 5.9 mn units

. . . AND CHINA EMERGED AS LARGEST MANUFACTURER, EXPORTER OF RACs ON BACK OF LARGEST DOMESTIC MARKET:

9 . . . AND CHINA EMERGED AS LARGEST MANUFACTURER, EXPORTER OF RACs ON BACK OF LARGEST DOMESTIC MARKET Source: Appliance Magazine Historical similarities with India: Large rural population, lack of basic infrastructure& low penetration (till 80’s) 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 China India In the last decade the Chinese RAC market has grown from 6 to 23 times the Indian RAC market, despite Per Capita PPP differential of only 1.7 times Today China is the largest manufacturer & exporter in the world with a CAGR of 46% in last 11 years China leading due to Economic reforms, localisation of ancillaries, dominance of domestic brands and entry of MNCs Lower Prices leading to increased affordability; single VAT of 17%. Export competitiveness due to large Scale operations for domestic market itself

THE HIGH INCIDENCE OF INDIRECT TAXES AND DUTIES IS THE PRIMARY CAUSE FOR THE HIGH PRICE POINTS:

10 THE HIGH INCIDENCE OF INDIRECT TAXES AND DUTIES IS THE PRIMARY CAUSE FOR THE HIGH PRICE POINTS Effect of government policy Typical 1.5 ton window AC Rs Key assumptions Manufacturing cost Manufacturing margin Freight, warranty Sales tax, octroi Excise duty Channel margin Consumer price Discount MRP 8115 2105 1000 1000 3395 4215 1170 22000 1000 21000 High import duty 30% for key components Weighted average range of 12%-21% Octroi/ entry tax of 3% 32% with 40% abatement AC is still perceived as luxury Duty effect Source: McKinsey Analysis & Interview of Players 46% - Rs 9,715 54% - Rs 11,285

THE LOW ABATEMENT IS NOT IN LINE WITH THE HIGH POST MANUFACTURING COST NOR IS THE EXCISE DUTY ON PAR WITH OTHER WHITE GOODS:

11 THE LOW ABATEMENT IS NOT IN LINE WITH THE HIGH POST MANUFACTURING COST NOR IS THE EXCISE DUTY ON PAR WITH OTHER WHITE GOODS Highest rate of ED and sales tax amongst white goods ACs: 32% ED on 60% of MRP; sales tax of 21% Refrigerator : 16% ED Driven by perception of AC as a luxury – today, AC is a need especially in a tropical country like India Further, amendment in the CST Act, almost all AC sales subject to LST which is higher than refrigerators Abatement of 40% not in line with high post manufacturing costs Post manufacturing costs of AC is 52.7% of MRP leaving a gap of 12.7% (given abatement of 40%) on which no abatement Source: Industry Sources

THROUGH CONTINUED EFFORTS BY PLAYERS BACKED BY GOVERNMENT SUPPORT SUPPORT, THE INITIAL PRICE OF AN AC CAN BE BROUGHT DOWN DRAMATICALLY:

12 THROUGH CONTINUED EFFORTS BY PLAYERS BACKED BY GOVERNMENT SUPPORT SUPPORT, THE INITIAL PRICE OF AN AC CAN BE BROUGHT DOWN DRAMATICALLY Typical 1.5 ton window AC Rs Key assumptions Current price Cost reduction effort by players thru design, scale & anciliarisa-tion Reduce excise duty to 16% Rationalise indirect tax and import duty structure Final possible price Single VAT of 15% Single import duty of 10% across value chain 21000 4600 2300 3100 11000 Source: McKinsey Analysis & Interview of Players

REDUCING EXCISE DUTY ON ACs FROM 32% TO 16% WILL BE TAX POSITIVE FOR THE GOVERNMENT:

13 REDUCING EXCISE DUTY ON ACs FROM 32% TO 16% WILL BE TAX POSITIVE FOR THE GOVERNMENT Current tax rev. (ST+ excise = 35%) Total loss due to decrease in tax rate at current volume Offset due to increase in demand at reduced price Net loss due to lowering excise duty to 16% Tax revenue potential (intermediate) Gain due to increased compliance Reduced costs due to scale leading to reduced prices and increased demand at new duty levels Total revenue potential Current tax revenue indexed to 100 Price elasticity for ACs X Price (Rs) Volume (’000 unit) Price elasticity of ~3, meaning a 30% drop in price will result in 100% increase in volumes Source: McKinsey Analysis & Interview of Players

FURTHER, MOVING TO SINGLE VAT AND IMPORT DUTY WILL NOT AFFECT TAX COLLECTION ADVERSELY:

14 FURTHER, MOVING TO SINGLE VAT AND IMPORT DUTY WILL NOT AFFECT TAX COLLECTION ADVERSELY Change in tax revenues Current total tax revenue indexed to 100 Current tax rev ST+ Excise -25% C.Duty – 24% Loss due to lowering VAT to 15% Loss due to lowering duty to 10% Tax revenue after reduct-ion in rates Indirect Tax gain due to increas-ed sales Direct Tax gain due to increas-ed sales Gain due to increas-ed compl-iance Gain in duty revenue due to higher consum-ption Total Rev. poten- tial Company driven actions to lower prices, hence improve demand and tax collections Reve-nue poten- tial Gains in tax revenue Gains in duty revenue Source:CII-McKinsey Study on “Learning from China to Unlock India’s Manufacturing Potential” Price elasticity for manufactured goods Price/Income Refrigerators Color TVs

THE FINAL OUTCOME WILL BE A WIN-WIN-WIN SITUATION FOR PLAYERS, GOVERNMENT AND CONSUMERS:

15 THE FINAL OUTCOME WILL BE A WIN-WIN-WIN SITUATION FOR PLAYERS, GOVERNMENT AND CONSUMERS Domestic AC market can be a huge market by 2007 Size of domestic market Rs 6280 crore and 4.3 million units with further growth possible Increased standard of living for consumer AC will become a need and productivity enhancer Growth in exports will earn foreign exchange for country Scale in domestic market will drive competitiveness in exports (e.g., Chinese exports of 5.9 million units driven of domestic volume of 14 million units) Household AC exports can be Rs 700 crore

ON THE OTHER HAND, NOT IMPLEMENTING INITIATIVES WILL CONTINUE TO HAMPER INDUSTRY PROFITS AND A MAJOR OPPORTUNITY WOULD BE LOST:

16 ON THE OTHER HAND, NOT IMPLEMENTING INITIATIVES WILL CONTINUE TO HAMPER INDUSTRY PROFITS AND A MAJOR OPPORTUNITY WOULD BE LOST Price (Index 1998 to 100) Total variable cost (Indexed 1998 to 100) Further price reduction very difficult at current costs Current costs difficult to reduce at current volumes Industry deadlock Price cost squeeze adversely affects players’ profitability Source: Analysis

PROPOSALS TO GOVERNMENT - EXCISE DUTY, 1:

17 PROPOSALS TO GOVERNMENT - EXCISE DUTY, 1 1 Excise duty rates and exemptions Excise duty rates - Air-conditioners (84.15) Excise duty and abatement to be brought on par with white goods (16% excise duty and 40% abatement) effective March 2003 Excise duty exemption Excise duty exemption to SSI to be withdrawn as it has outlived its purpose & large gap between the duty payable and the input duty is a potential threat for leakage in revenue Locational exemptions for manufacturing in North-East and Jammu for air-conditioners to be repealed as this has led to creation of finishing, packing & invoicing hubs, adding to fragmentation of manufacturing and inability to capture scale economics This exemption destroys value for government, players and consumers and confer none of the intended benefits to the system The exemption is financially attractive due to large gap between duty payable at 32% and all inputs at 16% with no requirement of value addition or minimum employment. In fact air-conditioner is the exception and not covered in the negative list If existing notification can’t be repealed, amend the notification by adding condition for value addition criteria for investment/employment

PROPOSALS TO GOVERNMENT - EXCISE DUTY, 2:

18 PROPOSALS TO GOVERNMENT - EXCISE DUTY, 2 2 Excise exemption for Cold Chain (84.18) Cold chain enjoys excise exemption under General Exemption No 66 in List 44 However , CENVAT credit on inputs is not available To maintain the spirit of exemption from incidence of taxes cold chain may be covered under payment of excise duty at 16% grant refund of Terminal Excise Duty (TED) to manufacturer or ; grant additional subsidy, equivalent to excise duty, to user

PROPOSALS TO GOVERNMENT- CUSTOMS DUTY, 1:

19 PROPOSALS TO GOVERNMENT- CUSTOMS DUTY, 1 1 Customs duty Broadly in agreement with the recommendations of Kelkar Committee: 2003-04 : 25% on finished goods and 15% on raw material, inputs and intermediate goods By 2004-05 : 2 tier structure with 20% on final goods and 10% on raw material By 2006-07 : single 10% import duty across value chain Recommend equal reduction of 10% in rate of custom duty to meet the target rates.

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