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Opinion

Protectionist stance or free trade: Why Budget 2022 should consider the impact of trade tariffs on Indian exporters

28/01/2022 9 Min Read

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Over the past few years, import tariffs and India’s attitude towards free trade have been a point of contention for many economists. Since 2014, India has on average seen a 5% rise in average tariff rates. Arvind Subramanian and Shoumitro Chatterjee have pointed out that India has raised import tariffs on over 3200 goods from most favored nations, which signals a protectionist stance to shield domestic industries. However, on the same hand, the government has, rightfully, come up with bills and policies which promote the export of products from India (Foreign Trade Policy 2015-20 and the recent re-establishment of the US-India Trade Policy Forum) and encourage manufacturing and assembly lines (Production Linked Incentive Scheme or PLI) to be set up in the country itself.

One can argue that these policies override one another given India’s retaliation from its trade partners. This could partly be because of increasing protectionism pre-covid and partly as a response to counter India’s increased import tariffs on raw materials and intermediate goods. Although the government’s move carried the right intent of encouraging foreign manufacturers to set up shop in India, it actually led to increased tariffs by India’s largest trade partners i.e., the US and the UAE.

In order to study the effect of such tariffs on India’s exports, let’s evaluate four product groups which the government has been focusing on over the past few years namely, textiles and clothing, capital goods, food products, and agricultural raw materials, and chemicals, fuels, and metals. For these product groups, we tried to check the sensitivity of India’s export growth to two variables: a) import tariffs imposed by India and b) retaliatory tariffs imposed by our trade partners from 2011-19. For this analysis, we have used data from the WITS portal.

The reason for taking the time period between 2011-19 and not the years prior to that is because of the size of the trade. From 2000-2010, India did not hold a big market share in the export of any product and the proportion of expenditure on Indian imports by its trade partners was negligible compared to their total import bill. Therefore, the elasticity of demand for Indian products was not affected by tariff impositions. Also, during 2000-2010, India was still in the phase of expanding its trade base by reducing all tariffs and making the economy more open, and therefore, there were no retaliatory tariff hikes by trade partners which is what this article intends to study.

Textiles and Clothing

A major proportion of India’s export growth in this sector comes from MSMEs. They have greatly benefited from the change in definition and the PLI scheme.

However, MSMEs in this industry face difficulties caused by tariff as well as non-tariff barriers. Covid-19 induced lockdowns reduced the capacity utilization ratio significantly for some MSMEs compared to larger companies due to their substantial dependence on export demand at times and the need for a continuous influx of skilled workers to grow.

We found textiles and clothing exports over the 2011-19 period have been elastic to changes in tariffs imposed on such products by India’s trade partners. Every 1% increase in tariff rates reduces the sector’s export growth by 1.1%.

It is important to note that retaliation on tariffs does not come on similar products but comes on products where the demand is more elastic. Countries tend to increase tariffs on those products for which they want to reduce external dependence. For India, materials for manufacturing like electronic items, metals, etc. make up the list where tariff hikes are prevalent. However, this is not the case for India’s trade partners, i.e. they have different trade policies and raise tariffs on product categories where they face a trade deficit. For example, the US has a trade deficit of US$ 8 billion with India for textiles, and therefore raised tariffs on Indian textiles when India raised tariffs on goods imported from the US.

Capital Goods

The capital goods industry is one where every Indian government has tried to push for an increase in exports but has not quite achieved that feat. The trade demand for capital goods is linked more to capital expenditures globally rather than tariff barriers. Analysis shows that for every 1% increase in Global Gross Capital Formation (GCF), there is a 2.7% growth in Indian exports. Even though this number looks good, it is not, relative to the higher base of growth for GCF. A 1% increase in GCF equates to an increase of approximately US$ 230 billion globally and a 2.7% increase in Indian exports equates to roughly US$ 1.5 billion which is less than 0.01% of a potential increase in global trade.

This problem can be attributed to the history of inverted duty structure on these goods, the high cost of inputs, and technological obsolescence.

Indian exports are mostly focussed on heavy earth moving equipment and heavy electricals which is surprisingly also the largest import category within capital goods. Important foreign markets, with high Capex potential, don’t encourage the import of Indian capital goods because Indian standard-setting bodies at times lack recognition. India’s major export partners like the US, UAE, Germany, etc. are countries with which India doesn’t have free trade agreements (FTAs), once again making capital goods from the country expensive. India has therefore not been able to fully utilize its FTAs given such non-tariff barriers and low competitiveness.

Inverted duty structure and high costs mean that businesses find it cheaper to import capital goods into India rather than buy them domestically. Specifically, an inverted duty structure means that the tariffs on imports of finished goods are lower than that on raw material needed to make these capital goods. Mainly, high tariffs are on imports of steel and electronic equipment, which are essential raw materials used for such goods, and currently, China is our main supplier for these.

The domestic cost of production for capital goods, however, has risen in tandem with these tariffs. Indian manufacturers prefer importing Chinese steel and electronic equipment due to better metallurgical advances and better technology, and they are relatively cheaper even after paying import tariffs. China is able to produce at lower rates than India because of its larger capacities and supply reserves. In 2019, China produced 996 million metric tonnes of steel which is over 53% of the world’s total supply. This makes China the price setter in the industry.

While the government needs to address the issues that place domestic producers at a disadvantage, the capital goods sector also needs to invest and upgrade domestic technological and production capabilities to emerge as a globally competitive producer and exporter. The government should facilitate these efforts to improve technological depth through adequate investments and incentives.

Food Products and Agricultural Raw Materials

Food products and agricultural raw materials is a product group that is rather inelastic to tariff changes by India’s trade partners and nontariff barriers as was proven by the covid-19 pandemic. However, there have been other trends that need to be acknowledged in this space.

The agricultural import bill for cereals like wheat and maize has seen a 9,675% increase, especially from 2013 to 2016, making it difficult for local farmers to explore the market. The government also abolished the import tariff on wheat, maize, rice, and other food crops in order to bring down food inflation and also reduced the harvest stored in government food storage facilities. These policies, especially at a time when the country’s farmers were facing the uncertainty around demonetization, left them with little working capital available for production. This coupled with problems like low productivity per hectare, a large domestic market to cater to led to a fall in India’s agricultural raw material exports.

Although, the government has managed to replace some of the export loss of agricultural raw materials through processed food products thus giving an industrial outlook to India’s agricultural sector. This is a great opportunity to move away from exporting primary products and promoting value addition within the sector.

Analysis shows that despite an increase in tariffs by India’s trade partners on processed food products and agricultural raw materials originating from India, exports have not been too sensitive to these hikes and sustained around US$ 6 to US$ 7 billion from 2011 to 2019. The use of digital facilities, technology, and an increased focus on value addition has done well for the Indian food processing industry. However, there still remains a cap over the potential growth rate of food products as long as things are not improved on the ground level.

Chemicals, Fuels, and Metals

The chemical industry has historically given high returns to shareholders over the long term. Indian chemical companies have given a CAGR of 15% in total returns to shareholders from December 2006-2019, according to research by Mckinsey and Co. It has been a consistent value creator with upcoming opportunities and a strong long-term growth story. Stricter regulations for Chinese chemical companies, trade conflicts, increasing technology, and consolidation in the sector globally provide an opportunity for Indian companies operating in the industry to scale up their operations and increase global market share from the present 4%.

However, chemical trade is dependent on the economic cycle in various countries since it serves as an important raw material/intermediary good for the production of final goods.

India has been a net importer in the industry with a trade deficit of approximately US$ 15 billion. For the industry to grow and corner more market share, reforms are needed at the ground level since the trade volume is inelastic to change in tariff differentials. Indian companies need to scale up and use technology and analytics to improve margins. Building self-sufficiency in areas like petrochemicals and ramping up export in specialty chemicals (adhesives, agrochemicals, construction chemicals) is a good way forward.

Conclusion

Out of the product categories analyzed, we see that most of the industries face problems at the ground level which need to be addressed in order to remove the cap from their growth potential in terms of domestic and international trade. We also saw that inverted tariff structures cause problems in India’s trade which is something that needs to be addressed for many industries. Import tariffs do harm export growth and put a cap on their potential which would not exist in the case of free trade between countries. However, there are also problems around the availability of credit, current logistical infrastructure, product quality control, and regulations among others that need to be addressed for India to boost its export growth further.

The article was first published on economictimes.indiatimes.com

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Pushkar Mukewar

CEO/Co-Founder at Drip Capital

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