How to avoid relapsing into a new dose of protectionism
US President Donald Trump’s import duty increases, with threats of further increases to come, have sparked fears of a global trade war. Trade experts in the US have stated that the administration’s action is bad for the US, and could be damaging for the world. Those looking for a silver lining say that if the threats get China to lower its barriers in some areas, and the US responds by reversing its own protectionist actions, we could end up with a net liberalization of world trade, albeit through bilateral threats rather than multilateral negotiations. However, this depends on China being willing to concede and that is far from certain. We will have to wait and see how it plays out.
Meanwhile, there is a more immediate danger. Trump’s respectabilization of protection will tempt many to argue that if the US can protect its manufacturing industry and create jobs by raising duties, should we not follow suit, since we want the same thing for our country? Some influential industry leaders have already advanced this argument and there have been reports in the press about a Bombay Club 2.0.
Relapsing into protectionism would be wrong and here is why.
Did we open up too fast?
One of the arguments advanced in favour of raising import duties is that we reduced import duties too fast. This is simply not true and it is important to get the facts right.
We started reducing customs duties at the start of the reforms in 1991. Our duty rates at that time were extremely high and it is true that we dropped them fairly quickly in the first five years or so. However, this reduction was offset by a sharp depreciation of the rupee, first because of the devaluation of July 1991 and then the shift to a flexible exchange rate which weakened the rupee. The combination of duty reduction with an exchange rate depreciation meant that competitiveness against imports was not adversely affected, and competitiveness in exports was greatly improved.
In 1997, P. Chidambaram, as the finance minister of the United Front government, announced that tariff rates would be brought down to Asean (Association of Southeast Asian Nations) levels within three years, ie by 2000. The comparison with Asean made sense then, and does so now as well. They are our neighbours, they have a combined GDP (gross domestic product) in dollars roughly comparable to ours so they represent a reasonable market for our exporters, we have a free trade agreement (FTA) with them, and our declared “Act East” policy suggests we should integrate with them much more, and much faster.
In the event, the duty-reduction target was not achieved by 2000. The National Democratic Alliance (NDA) government repeated the objective, but failed to achieve it. The subsequent United Progressive Alliance (UPA) government also failed to do so. Incidentally, for the first ten years, consumer goods remained fully protected despite duty reductions because there was a complete import ban on consumer goods. This was lifted only in 2002, ten years after the reforms began. There is no way our trade liberalization can be called too fast.
Did we get the exchange rate wrong?
Before looking to higher import duties to help domestic industry, we should consider whether the problem lies in poor exchange rate management. The Reserve Bank of India (RBI) index of the real effective exchange rate of the rupee against 36 currencies of our trading partners shows that the exchange rate has appreciated by about 20% over the past four years. If this real appreciation had not occurred, our domestic producers would have been that much more competitive against imports, and there would be no need to raise import duties.
The architecture of macroeconomic management that we have evolved should have had three pillars, with clear policy guidelines for each. One pillar is obviously fiscal prudence, which is now well institutionalized in the form of fiscal trajectories for both the Centre and the states. The finance ministry is responsible for ensuring that these targets are met. The second pillar is monetary policy in the form of the repo rate. This is now set by a six-member monetary policy committee on the basis of “flexible inflation targeting” which gives primacy to meeting an inflation target, while also keeping in mind the need of the economy to achieve its growth potential.
The third pillar should have been exchange rate management, but this is missing. We have no acknowledged policy for the exchange rate. When the rupee depreciates in nominal terms, the RBI usually responds with a time-tested formula: “We are not committed to defend any particular level of the nominal exchange rate. The exchange rate of the rupee is determined by market forces, but the RBI stands ready to intervene when necessary to prevent undue volatility in the foreign exchange market.” This is a good formula to deflect pressure from agitated politicians demanding a “strong rupee” as some kind of signal of strength. However, it is not a sufficient guide for exchange rate policy, since it would allow a real appreciation to take place (via an excessive rate of inflation) with no need for the RBI to intervene as long as the nominal exchange rate is not too volatile.
This does not make sense. We need a clear policy direction to RBI to ensure that any departure from some target real effective rate will be corrected. The correction could be achieved through direct intervention in the forex markets to push the exchange rate in the desired direction, or tightening of capital controls. There is no need to announce precise targets, as for inflation, but there should be an understanding between the finance ministry and RBI on how to intervene and to what extent.
An explicit exchange rate objective could create a potential conflict with the inflation target because pushing a depreciation might be seen as stoking inflation through its impact on import prices. However, if we are pushed to raise customs duties instead, it will have the same effect on prices. It is a difficult balancing trick but that is what macro policy is all about—striking the right balances.
Some genuine customs duty problems
One aspect of our import duty structure does need correction, and that is “tariff inversion”. This problem arises when import duties on inputs are higher than on the final product. In such cases, the “effective protection” of value added in the final product is less than the nominal rate of protection given by the import duty. If the duty rate on the imported input is high enough, the effective protection can even become negative. This should clearly be corrected.
The appropriate way of correcting tariff inversion is to reduce the rate of duty on the input. A major source of tariff inversion is the relatively high duty rate on some basic inputs including steel. Raising duties on steel is viewed in the public mind as protecting “our” steel industry from “foreigners”. This makes it look as if it is only the foreigners who lose from protecting steel. In fact, the foreign steel companies lose only the market share they might have gained with lower duties, assuming the Indian steel producers would not have been able to compete by lowering costs. In fact, the real cost of high duties on steel and other basic inputs is actually borne by the downstream industry, which then has to pass on the higher costs to Indian consumers. If the downstream users find it difficult to compete with imports, they in turn will lobby for import protection.
The cost of protection is ultimately borne by domestic consumers and also by exporters who face a higher domestic cost structure with no corresponding support for competing in world markets. Elementary trade theory used to teach that a tax on imports is actually a tax on exports. This lesson needs to be kept constantly in mind.
Does make in India call for protection?
It is sometimes said that “Make in India” cannot succeed if we follow a policy of maintaining low customs duties and leave everything to market forces. This is a straw man since no sensible person has ever argued that all we need to do is to lower customs duties and leave the rest to markets. Developing a competitive domestic industry requires a number of supply-side conditions such as (i) good quality infrastructure, especially power supply from the utilities at a competitive price not burdened by cross subsidy; (ii) good transportation and logistics; (iii) ease of doing business in obtaining necessary regulatory permissions and interacting with government agencies; (iv) easier access to land; (v) good access to bank finance, especially for small and middle-scale industry; (vi) simple and transparent tax laws with minimum scope for harassment; and finally (vii) flexible labour laws which would encourage employers to expand to a scale where they would have to deal with a large labour force.
Businessmen agree that all these conditions are important, but they tend to think that because the government will never deliver, it is best to seek higher levels of customs duties as a quick solution. They need to reflect that a more supportive exchange rate would be as effective as customs duties for those competing against imports, with the additional advantage of helping exporters. Would this create problems with other countries? It shouldn’t as long as we are not running large current account surpluses.
The poor performance of non-oil exports in recent years highlights the problem of loss of competitiveness. Non-oil exports in the past four years have been more or less stagnant. With the current account deficit now rising to around 1.8% of GDP, we need to think seriously about shoring up export performance. Correcting the exchange rate will help.
It is good to look for simple solutions, but protectionism is not a simple solution. It is simplistic.
Montek Singh Ahluwalia was the deputy chairman of the erstwhile Planning Commission.
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