India needs to plug in to global value chains

Today’s internationalised production systems are based on global supply/value chains (GVCs) running through many countries. The importance of GVCs has been increasing over time, despite the recent setbacks to globalisation on a multilateral basis. At the same time, trading blocs and FTAs have been proliferating and, correspondingly, bloc-based (often geopolitical) GVCs are replacing earlier GVCs.

Notwithstanding India’s economic globalisation starting in 1991, with sharp reductions in tariffs and dismantling of import quotas, in recent years, some reversal has taken place toward a more protectionist regime. Despite signing bilateral FTAs with several countries, India shied away from joining the Regional Comprehensive Economic Partnership (RCEP), even though a large segment of GVCs for manufactured products like consumer electronics is centred in Asia. The philosophy of ‘Atmanirbhar Bharat’, or selective nurturing of some Indian industries (thus seeking to pick potential winners) behind a protective wall is gaining ground over the forces of liberalisation in India.

Even if we accept that the days of free trade are over in India and the world, a question remains: Which policy instrument is better for fostering the chosen industries: import tariffs, depreciation of domestic currency, or production-linked incentives (PLIs)?

Some lessons emerge from our own historical experience. One of the major reasons why India did not face ‘de-industrialisation’ or exhaustion of forex reserves (as was feared by some critics of liberalisation in 1991), despite huge reductions in import duties and dismantling of import quotas, is that exchange rate protection gradually replaced protection provided by tariffs and quotas. Note that if the exchange rate moves from Rs 15 to a dollar to Rs 75 to a dollar, it is equivalent to a 400% uniform import duty, apart from providing a uniform 400% export subsidy. This has the additional advantage in that it is free from lobbying for protection by specific industries/firms.

Selective import duties, apart from the lobbying effect, create a bias in favour of producing for the protected domestic market. Resources would go into more profitable import-competing sectors and away from the export industries. Given this in-built bias against exports, the graduation from the import-competing stage to the export stage (as it happened in Japan and South Korea) would not occur naturally, unless adequate incentives are provided for exports. Even if duties on imported inputs are rebated to exporters, this is an additional hassle which can be obviated with free trade plus exchange rate protection. Note that under WTO rules, export subsidies are not allowed, but exchange rate depreciation is permissible. This is an additional reason for preferring exchange rate protection over tariff protection.

Even if it is accepted in principle that import duties on inputs should be lower than on outputs, in practice with a complex economy-wide input-output matrix, it is difficult to ensure this goal. The same product (say, steel) is an input for some firm (say, Tata Motors) but an output for some other firm (say, Tata Steel).

Further, while granting tariff protection, focus should be on ‘effective tariff’ or protection to domestic value-added, not ‘nominal tariff.’ There may be a huge difference between ‘nominal tariff’ and ‘effective tariff’.

For example, suppose the free trade price is 100, cost of imported components under free trade is 95 and, hence, value added under free trade is 100-95 = 5. Now, a nominal tariff of 20% is imposed on the finished product only. The domestic price of the finished product becomes 120. Value added under protection becomes 120-95 =25. Effective tariff or protection to domestic value added is now = (25-5)/5 = 4 or 400%.

So, in this example, a small nominal tariff of 20% implies an effective tariff as high as 400%. Thus, focusing on nominal tariffs may hide an excessively high or low or even negative (depending on the structure of tariffs on both inputs and outputs) effective tariff or true protection accorded to domestic producers.

Given the choice between tariff protection and PLI scheme for some carefully selected industries, economic theory would prefer PLI as it is basically a production subsidy and does not create a bias against exports (as is the case with tariff protection). In addition, import duties hurt consumers by raising prices paid by the domestic consumer (our objective is to encourage more domestic production and not to discourage domestic consumption of such goods).

PLI, by raising only the (subsidy inclusive) price received by the producer (not the price paid by the consumer), is free from this undesirable side effect. The only practical problem with PLI (unlike import duties which bring in tax revenue) is that this subsidy scheme has to be financed from budgetary resources. But then, if domestic production of such goods increases as a result of PLI, total revenue collection from other taxes (like excise tax, GST) would increase.

Finally, India needs to be a member of some big trading bloc. India may prefer a Japan-led FTA like the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which leaves out China, if it is felt that China would go on indulging in non-transparent anti-competitive practices and is a major geo-political rival of India.

Given the dilution of discipline imposed by the rules of a weakened WTO, we need to voluntarily subject our industries to the discipline enforced by the rules of a trading bloc/RCEP/FTA on a reciprocal basis. In today’s world, with the growing importance of global supply chains, FDI would go to a country to use it as an export base (rather than catering entirely to its protected domestic market) that has access to a big unhindered regional market provided by a trading bloc and allows free flow of inputs and outputs within the bloc.

Of course, to make India an attractive export base, we need to improve our infrastructure, labour skills, ease of doing business etc. Even here, one may hazard a guess that if exporting becomes a matter of survival for some industrialists in a trading bloc, this may create a lobbying bloc and generate additional incentives to improve these matters either through pressuring the government or through their own initiatives (like undertaking investment in roads, ports, power generation, industry apprenticeship etc).

(The writer is a former professor of economics at IIM Calcutta, India, and Cornell University, USA)