After the Multi Fiber Arrangement (MFA) is phased out, the textile industry of developing economies like India will have a reason to be optimistic about the long-term growth opportunity. The textile manufacturers will have a chance to increase the share of exports to the European Union and US markets.

This development will have a positive impact not only on the textile sector of the country, but also on the economy as a whole. So let's try to understand as to how MFA actually works and how will Indian textile companies benefit, post-2005.

Also Read India to gain most after textile quotas go: US

Before going any further, the importance of the textile sector on the overall growth prospects of the economy over the long term cannot be understated. Currently, the textile industry is providing employment to 18 per cent of the India's work force and contributes to around 6 per cent to the country's GDP and around 22 per cent of the India's exports. So, is MFA a boon or a bane?

MFA is an agreement through which a particular country is restricted to export its textile products beyond a certain level to European and US markets. So, a particular quota is fixed for each country (in terms of quantity, say 1 million shirts etc.), and no country can exceed the quantity assigned.

Thus, the motive behind this agreement can be either to provide a window of opportunity for the under developed and developing economies or it can be to save the interest of the domestic textile industry of European Union and the US.

After a particular quota has been assigned, the interested exporters have to contact the textile ministry (in India, for example) and bid for the quantity to be exported. The government assigns the quantity that a particular company can export on the basis of certain parameters like past performance, new investor entitlement (in order to promote investments) on a first come first served basis.

The selection criteria for different categories like garments, yarn and fabrics are different. For example, in garments, 70 per cent of the quota is granted on the basis of past track record, 15 per cent for new entrants, 10 per cent on the first come first serve basis and only 5 per cent as non-quota entitlement.

However, a company can buy a quota from another company in the market by paying some premium. For example, if a company X has a quota to export only 10 mm of cloth, it can buy the quota of company Y at a premium and increase the total quantity that can be exported. Just to put things in perspective, inspite of having capacity and capability, currently, India's share in the international garment market is just 3 per cent, due to quota restrictions. Let's have a look at the size of the opportunity post 2005.

Denim: The total denim production capacity of India is 220 million meters (mm), whereas the current global denim consumption is around 3.9 bn meters and is growing at 4 per cent per annum. The consumption pattern chart given below shows that European and the US together constitute around 69 per cent of the total global denim consumption.

Shirting: The total domestic shirting capacity is around 65 mm whereas the global shirting consumption stands at around 1.3 bn meters. The high value (superior quality) global shirting demand is growing at around 6 per cent per annum. The major consumers of high value cotton shirting are European countries, Japan and the US. The current export quota for Indian shirts stands at around 30 m pieces, which is marginal.

Thus, looking at the global demand size, we can say that the potential of Indian companies is huge. Consider the cost competitiveness of the Indian sector now.

The textile chain can be broken in three stages. At the end of first stage, the fabric is manufactured. The second stage can be identified as garmenting (i.e. converting fabric into garments) and the third stage will be branding and retailing. The first stage begins with spinning and continues till the grey fabric is ready. Raw material forms the major chunk of cost in the first stage (around 50 per cent).

Cotton is the most important raw material for the denim and shirting industry. Here, India is the third largest cotton producer in the world and the cotton prices are comparatively cheaper in India as compared to international markets. So, we are at the advantage.

The second stage involves processing and garmenting of the fabric produced. India has a major advantage in this segment, as this stage is highly labour intensive. As evident from the graph below, labor cost as percentage of total cost in India is very low as compared to other countries.

Apart from cheap labour, India has skilled labour too, which also gives an edge over other countries.

The third stage can be recognised as branding and retailing of the garments produced. This is the higher end of the textile chain, but it takes time for a brand to gain market share. Indian textile majors have already started entering this segment but we believe the process is time-consuming post the MFA scenario.

The government has set an ambitious textile export target of $50 billion by 2010 as compared to $11 billion currently. However, the government is putting in efforts at lending a helping hand to the textiles industry, which has been in doldrums for quite a few years now. In order to achieve the growth target, a few important initiatives have been taken by the government.

The government has already set up a textile reconstruction fund to help reduce the effective interest burden on viable textile companies. This fund targets reduction in interest rate for all borrowers in range of 8 per cent-9 per cent. Banks and financial institutions have burnt fingers in the past by lending to this sector. Hence, advances have been costly. This move by the government will benefit the sector a long way.

We would like to conclude by saying that there is a huge opportunity lying ahead for Indian textile manufacturers in post MFA era, as the markets will no longer be restricted. But there will be competition from countries like China, Sri Lanka, Bangladesh, in terms of cheap availability of products.

But when it comes to fashion trends, we believe Indian companies will have an advantage. As far as cost competitiveness is concerned, the larger players in the Indian textile sector are well placed to compete.

But the Indian textile sector has a long way to go to achieve a sustainable competitive advantage. The industry is very fragmented and access of finance and technology has been affecting growth prospects of the smaller manufacturers. In terms of technology and the ability to produce products in the large-scale, we still lag behind others and to that extent, investors to remember that there are only few companies in this league. Impractical labour laws also restrict large players to lay off redundant workers to improve competitiveness.

Therefore, the risk profile of the sector is also higher, despite the growth opportunity, on account of lack of control over input costs. Overall, it is a balanced scenario and it remains to be seen how Indian companies tap this opportunity.

Equitymaster.com is one of India's premier finance portals. The web site offers a user-friendly portfolio tracker, a weekly buy/sell recommendation service and research reports on India's top companies.