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Trade Policy Dilemmas faced by India: A Tale of Two Industries

, December 9, 2014, 0 Comments

trade policy india dilemmas-MarketExpress-inNotwithstanding the globally sharpening focus on multi-lateralism (read WTO, food security and trade facilitation) and pluri-lateralism (read Trans-Pacific and Trans-Atlantic Trade and Investment Partnerships), we all want all our industries to flourish despite the increasing global competition.

How do we do this? Well, there are two ways. With little protection of the domestic industry, it may learn how to outperform its competitors from abroad in the domestic market. This may probably ensure a structural development of competitiveness in the industry eventually, helping the domestic industry grow up as a global player.

This is the crux of export-oriented industrialization. This model had been followed in the past by the countries like South Korea, with great success.

Another way, which has been conventionally popular among the Indian trade policy-makers, is to protect the domestic industry heavily by imposing huge tariffs on imports. Thus, the domestic market is dominated by products from domestic industries as the imports are rendered too expensive. In a country where imports are dominant, this policy would tend to substitute the imports with domestic production. This is what we economists call import-substitution, which is usually implemented when there is an ‘infant-industry’ condition, whereby the domestic industry is too uncompetitive to face global players.

On the face of it, ‘import-substitution’ looks like a sensible thing to do: imagine how many Chinese motorcycles would flood the Indian market if we reduce the protection for Indian motorcycle industry. Roughly, our tariffs on Chinese motorcycles are about 50%, while they may be about 50% cheaper than Indian motorcycles.

But, reducing the tariffs gradually would force the Indian manufacturers to somehow reduce the costs by increased efficiency, better technologies, research and development, reduced wastage, etc. This is is not a mundane statement, but is a well-researched conclusion arrived at using field-surveys and econometric analysis in an ICRIER study sponsored by the Govt of India.

A simple evidence exists in the trade policy structure of Indian auto industry. Auto-components sector, which primarily produces all types of parts required for the industry, has tariffs close to 8%, which has been systematically reduced over the years and this sector has expanded phenomenally, especially in terms of exports. Automobiles and motorcycles segment that has enjoyed immense protection has not grown so much in terms of exports, on the other hand.

This raises the important question of how to deal with diversity in the tariffs within an industry like automotives in India. Often while conducting research on trade policy for framing research-backed arguments in the trade negotiations such as WTO, one has two different alternative approaches to adopt.

Firstly, as most of the consultancy organizations and governmental policy researchers do, one can consider all the hundreds of sub-sectors in the auto industry and do some impact-analysis. This approach misses several important points, such as the inter-linkages in the economy and overall welfare implications. For example, such analyses can seldom deal with the fact that auto industry depends on steel and plastics and they can seldom quantify how many dollars will Indian public at large lose by cutting some tariffs.

A second approach, adopted by academicians and some governmental researchers, is the Input-Output based approach or the Computable General Equilibrium approach. Here, one has the opportunity to consider inter-sectoral and international linkages and compute the approximate welfare measures of the tariff policies. These models are understandably complex and data-demanding, so they typically deal with aggregate data. For example,GTAP Data Base, which is prominently used in such simulations, gives Motor Vehicles and Equipments as a sector, which consists of the dozens of sub-sectors within the auto industry.

So both approaches have their shortcomings. We developed a model that would marry both approaches so that we can get the best of both worlds to analyze the issues in the trade policy of Indian auto industry. While our conclusions pointed out the better performance of this model, one of the few lessons for Indian trade policy makers here was this: slowly but steadily, reduce the tariffs in the automobiles/motorcycles.

Steadily – because the customer stands to gain from the lower prices and the producer may become more cost-competitive in due course. Slowly – because drastic reduction of tariffs will perhaps wipe out the Indian industry due to the flooding of imports from countries like China. Further the extent of reduction should be specific to the sub-sectors, based on their competitiveness, size, etc. – something to investigate in future. Is’nt it amazing to see such simple and practical policy measures emerging from extremely complicated models and data?

In the textile industry, India has been more active towards the export-oriented industrialisation policies in recent years, due to tariff reduction commitments as a result of multi-lateral trade negotiations amidst other free trade agreements, etc. The main policy of export incentivisation is just subsidizing exports. This is prominent in key sectors such as textiles. However, World Trade Organization (WTO) recommends all members to phase out their export subsidies.

Now our policy-makers face a dilemma. Should we just remove them all abiding by WTO commitments or keep protecting the exporters? While this may render the export-oriented industries susceptible to tighter competition in their import markets, productivity improvements could help offset such disadvantages.

More specifically, the money saved by the government by cutting subsidies can be used to increase productivity by better infrastructure, etc. A paper I wrote with Vasundhara Rungta, which is forthcoming in the journal Margin, explores the interaction between these two different aspects to evaluate the economy-wide impact of the export subsidy reforms and productivity improvements in Indian textile and clothing sector.

Our analysis stands on various policy simulations applying the general equilibrium model of the Global Trade Analysis Project. The welfare impacts of the removal of the Indian textile and clothing subsidies in millions of US dollars shows that India is expected to encounter a loss of about 71.5 million US dollars, while the other Asian countries may gain about 218 million US dollars. In a different scenario, we simulate the impact of a complete phase out of subsidies provided to the textile and clothing industry of India and a simultaneous increase in total factor productivity growth to 3.5 %.

This leads to a net positive welfare change! We conclude that merely removing subsidies is not enough as the policy makers often worry. Investments in total factor productivity should come about simultaneously, probably by employing the surplus funds from saved subsidy payments into areas like Research and Development (R&D) and infrastructure, in enhancing total factor productivity. This conclusion may be qualitatively generalised for any sector in the world which is examined for export subsidy reforms, but similar economy-wide studies are recommended for specific cases.