Jul 9, 2021

Dominant Currency Paradigm - An interesting progress in open economy macroeconomics after IS-LM-BoP

Does it matter if the exporters/importers of a country show preference for a certain currency while invoicing the trade? I had dabbled with this few years ago here, which was based on the Dominant Currency Paradigm presented by Gita Gopinath, Casas et.al. The expanded theory titled "Dominant Currency Paradigm" (DCP) was published at the AER in 2020 and the corresponding replication code with data is made available here

DCP is a significant development after Mundell-Fleming's model using IS/LM/BP curves which has been a workhorse model for decades. Mundell-Fleming (and the Devereux model) uses bilateral exchange rates to arrive at equilibrium rates, whereas DCP takes into account the additional factor that countries may use a third currency as invoicing currency while trading bilaterally. For example, traditional Mundell Fleming model for trade between India and Japan would use INR/Yen pair to understand disequilibrium whereas the actual invoicing of this trade may happen in  USD due to various factors. DCP corrects this by allowing usage of third currency, and goes on the prove that for the world that we are currently in, the USD is the dominant currency, with most third currency invoicing taking place in USD. India invoices around 86% of its imports in USD and around 10% in Euro as per the paper, the importance/pitfall of which would be clear in a moment. 

Let me summarize DCP's key takeaways: 

- The terms of trade for a country are uncorrelated with exchange rates in short and medium term: Mundell-Fleming predicts that, because prices are sticky in the producer's currency (Producer Currency Paradigm - PCP), a nominal exchange rate depreciation is associated with a depreciation of a country's terms of trade.  That is, currency depreciation would lead to increase in ratio of price of imports to price of exports. If INR/USD deprecates to Rs 100/USD, our import prices would shoot up leading to deteriorated terms of trade with the USA. A counter argument was given by Devereux et.al. that as the prices are sticky in destination country's currency (Local Currency Paradigm - LCP), a depreciation in exchange rate would lead to appreciation of country's terms of trade. With 100 Rs/USD, our exporters would now get more rupees for each dollar worth of goods exported and hence terms of trade would improve. 

DCP researchers find no such correlation. They find that the terms of trade are not correlated with bilateral exchange rates - neither PCP nor the LCP holds. This is counter-intuitive as it is usually believed that nominal appreciation/depreciation of currency would worsen/improve the terms of trade depending on whether the country imports more or exports more. Rather the terms of trade are defined in a way to align to this view and this mental model drives a lot of understanding about future direction of currency movement. If this is not true, a lot of other things that we know about forex markets appear to be standing on shaky grounds. The researchers have used non-commodities data, after excluding agri commodities (chapter 1 - 27) and certain engineering commodities (chapter 72-81) constituting almost 25% of total trade. Thus the research covers 75% of the international trade as per my estimates. (The paper says it covers 91% of trade, I am not sure how) 

- Dollar is the dominant currency and influences the international trade disproportionately: DCP takes a stand that neither PCP nor the LCP models hold true when it comes to international trade, but it is a small set of dominant currencies led by USD that determines the direction. The paper estimates that a 1% appreciation in USD against all other currencies leads to a 0.6% shrinking of global trade after controlling for business cycles.

The effect of dollar appreciation on exports outweighs bilateral currency appreciation (appreciation of recipient country's non-dollar currency).  If India is exporting to Japan, the effect of dollar appreciation would lead to greater fall in exports when compared with appreciation in Yen. This is the effect of invoicing Inso-Japan trade in dollars. 

- The price pass-through for non US economies  is directly in proportion to trade invoiced in USD, the dominant currency:  The trade mechanism for exchange rate adjustments work for all economies except the dominant currency economy, i.e. USA. This leads to two further findings. US economy is negligibly impacted by price changes in Dollar - which implies that the inflation targeting monetary policies run by other economies has insignificant impact on US. On the other hand, price changes in US arising out of monetary adjustment leads to impact on other economies through trade route (there may be other mechanisms of adjustments through capital flows which is not dealt directly). The exchange rate pass throughs are significant for all economies but US is immune to it. Any adjustment in US has to happen through other routes other than import price pass through. 

Where does that leave us? A revision is in order in the way people construct mental models about exchange rate effect on exports. A general thinking is that a depreciation in rupee is good for our exports as we become more competitive. The paper shows that it may be contrary and the trade may actually shrink when the dollar gets stronger. 

What next:

One concern I find in this paper is that there is no discussion about hedging of currencies at the time of invoicing. Usually, long term players cover their risk through currency positions they take while raising invoices in order to immunize against currency fluctuations in short and medium term. This is especially true for non-commodity trades. This, and the fraction of players who do this, may have a significant role in the way the pass through works. This needs investigation. 

Also, it is difficult to imagine that if a country mandates local currency pricing (imagine India issuing a fiat to quote all invoices in INR), it would somehow lead to lesser pass through. The exchange rates are an indirect indication of relative prices and to imagine that the way it is quoted leads to effect on trades is counter-intuitive. I will take time to get used to this new smell. To that extent Mundell-Fleming/Devereux made more intuitive sense. 

Jun 24, 2021

Fourth industrial revolution and India's demographic challenge

Klaus Schwas coined the term 'fourth industrial revolution' to describe the confluence of emerging technology breakthroughs, covering wide ranging fields such as artificial intelligence, robotics, telecommunication revolution such as 5G, the internet of things, driverless vehicles, 3D printing and additive manufacturing, nanotech, biotech, materials science, energy storage and quantum technology. On the surface, it appears to be the next logical step from the third industrial revolution where electronics and IT were leveraged for production and service delivery. However, as Schwas argues, the growth of these in future would lead to exponential impact on various spheres. The velocity, scope and impact of these changes may take directions that may not be wholly predictable, affecting all fields from agriculture, education, trade, warfare, manufacturing and everything in between. There is a good (and urgent!) reason why policymakers should be abreast of developments in more than a cursory way. It would not only preempt the adverse affect on the country, but it might also help to prepare policies to take advantage of the developments. 

The traditional economics still looks at manufacturing and trade from last century's perspective. This needs an urgent revision, especially when it comes to a developing economy context. The macroeconomists still dabble in general grand equilibrium models that went nowhere when financial crisis hit. The microeconomics still begin with economies of scale and theories of firm that could barely explain the growth of IT and services firms such as Amazons and Facebooks which operated without profits for long time. Theories based on Ricardo's comparative advantage are still being taught in graduate schools with wine and cloth being traded between England and Portugal. The sad truth is that trade practitioners still use indices such as Balassa's "Revealed Comparative Advantage" to arm themselves during negotiations, advised by advisors trained during last century. The theories are not to be blamed as they played vital role in understanding the factors that contribute to development. The models had their use. The blame must lie with people who have turned these theories into religion despite piling evidence that points to the staleness. 

There is an acknowledgement, lately, in the various circles about gaming of globalization by countries such as China and the backlash may be seen in terms of waning political appetite for further globalization. However, the firms in a capitalistic economy such as US would nevertheless push for optimization through supply chain relocation into countries where cost of production is cheap. However, the cost advantage gained through cheap labor price would erode through advancement in technology mentioned in fourth industrial revolution. The threat of automation displacing labor is being discussed at various places in the last five years. However, the exact mechanism is not well known and the suggested panacea of skilling the labor might at best produce mediocre results, or at worst might not work at all. This would have serious repercussions for young countries such as India unless we take remedial steps. 

Aug 22, 2020


(This post originally appeared at Swarajya magazine here

During the 1990s, computing faced a unique ‘memory wall problem’ due to increasing processor clock speeds but relatively slow memory speeds. While processor speeds increased at 50% year on year (Moore’s law) memory speeds increased only by 10%. Imagine a talented and quick chef bogged down by a slow assistant, who takes longer than usual to fetch ingredients from the pantry. The solution was found by using a ‘cache’, a smaller but faster memory placed nearer to the processor, thus avoiding multiple trips to the larger and slower main memory. This was like the chef getting a shelf that stocked all recently used or frequently used ingredients closer to his table. Today we have multiple caches at multiple levels in any given computer. Similar problem of earth-size arose when digital contents were to be served to multiple users across the globe. Imagine Netflix maintaining data centers only at US and trying to service the users across the world. The geographical distance that each data packet needs to travel would be huge and may clog the network affecting speed and user experience. The solution is again in a form of caching created by ‘Content Delivery Networks’whereby proxy servers and data centers are maintained nearer to the users, optimizing the content travel over the network. One of the largest firms in this field is Massachusetts headquartered Akamai which roughly covers a quarter of the web traffic today. Akamai is present wherever the users reside and maintains around 3 lakh servers in 136 countries and claims to have 85% of internet users within single network hop to an Akamai server. 


Going local as an optimization technique was a natural development in the above cases. This may also apply to the world of manufacturing. Supply chain management is known to use such optimization techniques while deciding on warehouse location. But when it came to manufacturing, scaling up at one location was usually considered an ideal way, especially in the recent decades. This is now changing, and China centered global production models is on the verge of being altered where production would take place in multiple geographies to cater to local markets. It will be the next logical step for production firms to survive in a de-globalizing world. Geopolitics, advancements in automated production techniques, declining appetite for globalization, rise in border barriers, and rogue behavior of China are the precipitating factors that would push this movement for change. We cannot term such optimization by production networks as ‘deglobalization’. A parallel term is ‘Akamaization’ – a solution where the firms go local in order to remain global.  Akamaization would arise in the beginning due to multinationals adjusting their international supply chains to the reversals in globalization by leveraging on Industry 4.0 advancements such as automated manufacturing, robotics and IoT. In the second stage, Akamaization would include growth of organizations that design their manufacturing processes to be agile and Akamaization friendly. 


The good years of globalization saw concentration of production in labor intensive countries. This was possible due to falling tariffs, technological developments, and logistics optimization such as containerization of cargo. The scale of concentrated production decreased costs and the decreased barriers to trade alongwith cheaper logistics ensured that geographical distances didn’t matter. The data suggests that this model peaked sometime around 2012-13, few years after the financial crisis.  Both in terms of merchandise trade as percentage of GDP as well as total merchandise trade as measured in current US Dollars terms has stagnated (or declined) after the recovery following financial crisis.  One may say that the world reached ‘peak trade’ during the first half of 2010s. The decades leading to peak trade were marked by growth and concentration of manufacturing in China and nearby countries including Taiwan, Korea and ASEAN. 

Akamaisation: Merchandise trade as percentage of GDP

 Fig: Merchandise trade as percentage of GDP - Source: World bank


Akamaisation: merchandise trade current USD

Fig: Merchandise trade in current USD - Source: World bank


There is no single explanation for peak trade. The most likely explanation is that the factors that drove the growth had run their course and there was not much that could be done further on. However, the decline starting thereafter and the expected decline in future would be of a different nature.  It’s easy to call it de-globalization, but for the adaptability of the firms that run the international value chains. 


In the last few years, after decades of embracing globalization, developed countries finally woke up to the unsavory side effects. ‘Hyper-globalization’ – a term used by Dani Rodrik – of the last three decades where capital as well as value chains cut across borders, is not proving to be a sustainable proposition in the long run as the free trade of hyper globalization type creates a losing side. The political setup of the losing side can’t explain away the job losses with consumer welfare or Ricardian theories. Free trade had peaked before the emergence of the protectionist political leaders who called it out. While the globalized model with zero barriers suit the multinationals, the politicians and policymakers increasingly realize the bad effects on domestic job growth and general prosperity. The backlash by the increasingly frustrated population is partially responsible for emergence of protectionist political leaders. Similar sentiments may also be seen in the prevailing mood of going local slogans such as ‘Make America Great’ and ‘Atmanirbhar Bharat’. While the free trade economists may rue the developments and sermonize about unlearnt lessons from history, it provides no solace to the multinationals who operate the international value chains and who need to explore alternative models to remain in business. Deglobalization by disengaging or shrinking their markets and business is not an option for the globalized firms. That’s where Akamaization steps in. 


Akamaization of a global firm involves higher level of integration and interdependence in terms of management, design, and product development while maintaining a network of production setups catering to limited geographies isolated by rising trade barriers. Imagine a global cell phone manufacturer rolling out new products every year but choosing to make similar models in different key geographies with significant market shares. Most components may be sourced locally to avoid border crossings. The manufacturing setup would cater to the domestic market, and export to those nearby markets where the market share is not significant enough to warrant setting up an independent manufacturing base. The optimization problem for an Akamaizing firm would involve variables such as direct and indirect cost of crossing borders, geographical distance, market size, investment and business costs etc. Akamaization may also happen due to geopolitical pressures. For example, Taiwan’s TSMC, the largest chipmaker in the world, has announced that it would be setting up manufacturing in US in response to Trump administration’s pressure to move critical technology back into US. 


For policymakers Akamaization starts with attracting ‘screw-driver’ technology where assembly operations would move in first, followed by indigenization of components. This can be engineered by carefully planned tariff and non-tariff barriers across the value chain starting with higher barriers for fully assembled products and moving down to smallest of the components in a graded manner.  A success story for India is the mobile phone manufacturing which got an upshot due to the border duty tweaks on mobile phones during 2016-17. Apple’s decision to set up assembly plants in India and further plans to increase local sourcing of components is an example of Akamaization. The growth of mobile phone exports from India may be seen below. 


Akamaisation: Export of mobile phone and parts from india

Fig: Export of mobile phones and parts from India in USD Billions - Source: UN COMTRADE


Now the Ministry of Electronics and IT is incentivizing production of electronics and mobile phone components in India through various capital investment and manufacturing linked support plans. This may further accelerate the trend shown above, not only for exports but also in terms of decreasing dependence on imports of electronics hardware. This support shall go hand in hand with border barriers for import of the components. It must also be noted that there would be limited scope for export led growth in an Akamaizing world in future, a factor that policymakers must consider while intervening. 


Akamaization would not remain restricted to fields such as automobile, electronics or technology products alone. Even in fields such as garments and footwear, there is a chance that the ever-changing fashion trends and the need to be nearer to the market may drive Akamaization. The high labor input in some of these fields may delay Akamaization, but beyond a threshold and with rising border costs, the cost benefit analysis shall tilt towards manufacturing near the markets, starting initially with the high-end segment. As the manufacturing technology improves with advances in technologies such as 3D printing and robotics, even the fields that were considered offshoring friendly would be relooked at. When Akamaization touches labor intensive fields, it may affect the employment potential of those fields. This would be a challenge for labor rich countries like India which should explore upskilling the future generation to cater to altered needs of the future industry. 

Akamaization also has the potential to divide world into groups based on mutual trust on intellectual property (IP) front. Like minded countries that are trusted with IP and show greater regulatory coherence would bond together. The experience of US and western firms with China has shown the importance of IP protection and preventing corporate espionage. This may build a new world order based on emerging alignments where trade and geopolitical interests converge, breaking away from the existing multilateral arrangements.  Firms would be more comfortable Akamaizing within the group. 


It is important to understand that Akamaization would happen under a certain set of conditions. These conditions include a significant market size and right policies for setting up manufacturing in the country. If the market size decreases, or if the border resistance rises to unsustainable levels where it no longer makes sense to transact anything across borders, firms may give up on the market over Akamaizing. The same goes for steps towards greater ease of doing business which facilitates easy Akamaization. It’s easy to miss the balance, and that would bring back the free trade economists who have been predicting doomsday since the time India tried to fix the distortions in trade arising out of poor policy choices in the past.







Apr 8, 2020

Would more COVID testing uncover more COVID positive cases?

It is alleged that India is not testing enough. The number of tests per million population in India stands at around 100 when compared against countries like USA which stands at 6300, or Italy which stands at 12000, or Switzerland which is around 19000 tests per million population. 

So, is it that because India is testing lesser number of people per million population, India is reporting less number of cases? Would more testing lead to uncovering of more cases, increasing India's infected count?

Ashish Chandorkar, in this Swarajya magazine article disagrees. Rightly so. He states: 
"What does the data tell us?

In India, out of the 100 high risk cases being tested for COVID-19, only 4 are testing positive.

Of those testing positive, roughly sixty per cent are either individuals who traveled from a foreign location or were part of the single source Delhi Nizamuddin congregation.

The positive cases per 100 tests is 17 in the USA, 19 in Italy, 23 in the UK, 24 in France and 37 in Spain.

What does this tell us?

That in spite of the fact that the USA has done more than 16 lakh tests and Italy has had more than 6.5 lakh tests, there is a need for more testing as a large fraction of people are turning to be COVID-19 positive.

Testing in itself is not a panacea to all the problems being associated with COVID-19. Testing for testing’s sake is of no use. Testing should be done for identification and for quarantine."

While that was my hunch too for long, and I agree with Ashish, I still thought of running the numbers quickly and plotted a scatter bubble for all data available for all countries across the world. Here it is: 
(A note here: We are talking about percentage of cases, not absolute numbers. While more testing will lead to more absolute numbers, the percentage positive would remain mostly a constant)

image for Test per million capita Vs Percentage positive cases COVID testing
COVID Testing - Would more testing help?

It's always tricky to explain a plot unless the intuition autoclicks for the onlooker. 
On the X axis you have the Tests per million on log scale. On the Y axis you have % of tests that turned out positive. No country reports that all tests conducted were found COVID positive. France comes close to a point where 1 in every 2 tests return positive. In India for every 25 people tested, one returns COVID positive. For USA it is one positive in five tests and so on for all countries as one can see. 

One may note that there is no correlation between percentage detection and per capita testing. It means that wider coverage won't necessarily lead to more detection of cases. To be sure, I have also plotted a best line fit which has almost no slope (slightly negative to be precise). This can be seen below (with a pinch of salt due to the Rsquared value): 

image of COVID test success percentage vs more per capital testing per million population
COVID Testing: Relation: Test success percentage(Y) vs More Per M capital Testing (X) 

So, the data supports the theory that more testing won't help unless we have more infections in reality.   By testing more, we will just go where Iceland is currently in the first plot. They are testing huge numbers with the resultant same level of success that we have in terms of percentage. We shall move on X axis without any change in Y. 

The data so far for India says that the infection level (on per capita terms) is very low, and there is not much transmission on the scale seen in other countries. When we juxtapose against the fact that India has been testing high potential cases (foreign returns, NZ contacts, first level contacts etc.) and still returning negative results, it bears all the more testimony that probably our level of testing is not to be blamed for low numbers. And if that is so, we have reasons to cheer. Either the lockdown has worked, or other factors such as malaria resistant people, hot/humid weather, demographic profile, inbuilt resistance etc is at work. 

The plot would also be interesting to watch over time for another reason. If the position of a country on Y axis doesn't change over time, or with increased testing, it would prove that a country exists with a certain tolerance for the infection/spreading which is a function of factors other than testing. Once unmasked, this factor would tell us what might further help. 

Above plot were generated on 8th April 2020. 

Updated figure as on 16 April is below: The point has just moved right. I won't be surprised if it goes and touches Iceland one day. 

COVID percentage detection has not changed for India - As on 16 April 2020

Updated figure as on 26 April is below: The point has just moved right as we have increased the number of test per million from around 200 ten days ago to around 450 currently. It's moving horizontally as expected. 

figure of COVID percentage detection has not changed for India - As on 26 April 2020
COVID percentage detection has not changed for India - As on 26 April 2020

Updated figure as on 03 May 2020 is below: One million tests completed for India. A Milestone reached today. The point has just moved right as we have increased the number of test per million from around 450 a week ago to around 800 currently. It's moving horizontally as expected. 

Updated figure as on 10 May 2020 is below:  The point has just moved right as we have increased the number of test per million from around 800 a week ago to more than 1000 currently. It's moving horizontally as expected. 

Updated figure as on 31 May 2020 is below:  The point has just moved right as we have increased the number of test per million from around 1000 in the previous figure to more than 2800 currently. It's moving horizontally as expected. However, there is a slight bump in Y axis by roughly around a percent (4% moves to 5%)

Updated figure as on 20 July 2020 is below:  The point has just moved right as we have increased the number of test per million from around 2800 in the previous figure to more than 10000 currently. It's not moving horizontally as expected and for the first time I see a slight vertical movement too. From 5% it is gone upto around 9%. Still much lower than 50% that some countries demonstrate but a movement up nevertheless. I would change my mind about the theory if it goes above 15%. 

Add caption

(Note: All data taken from Worldometer. I have placed the code for generating the labelled bubble plot at https://github.com/tirumalakv/COVID19plot.git to tinker around if you are interested. The plot with the regression line was generated on MS Excel)

Dec 8, 2019

WTO moratorium on E-Transmissions and OECD Pillars for digital economy

Moratorium on Cross Border E-Transmissions

If one imports a book into India, one will pay applicable customs duty (currently 10% basic customs duty, and all applicable cess/welfare charges). However, if one downloads the same book over Amazon Kindle, one gets it duty free. Kindle books are almost always cheaper than their paper counterparts and the zero import duty is one of the factors keeping it that way, other factors being savings on printing/paper, transportation etc. This is an example of how the moratorium on international cross border taxation on Electronic Transmissions (ET), adopted by WTO in 1998 affect the prices. 

image of Digital imports in world
Share of Digitalised Products in Global Imports - as represented in UNCTAD study

Also, there is the question of direct taxation, in terms of corporate taxes or taxes on profits from the earnings made in India for companies who are highly digitalised in terms of delivery/users/markets (Amazon cloud services, Facebook, Google), and where it is not easy to actually segregate the amount of profits that arise out of operations in any particular tax jurisdiction/country. I am not aware how Amazon India accounts for the kindle sales in India, and the subsequent profits or lack thereof and whether they are adjusted against subsidised goods sales and so on while filing the annual tax statement with the Indian government. The case becomes complicated when you look at free ebooks offered under 'Kindle Unlimited' scheme.  It is not easy to establish the nexus between the operations and profits arising in any one country when the model is highly digitalised. Therefore, in a digitalised world, where companies are operating in a highly digital model, both indirect and direct taxation becomes a vexing issue. While WTO bothers more about indirect taxation such as customs duties, OECD bothers about direct taxation such as corporate tax on profits and issues related to Base Erosion and Profit Shifting. 

For those who understand how digital transmission works, the issue of tarrification of electronic transmission (WTO issue) and the issue of taxing profits of digital multinational organisations (OECD issue) are two sides of the same coin. You cannot actually isolate one without stepping into the other part. But for now let's deal with them separately and frame the policy questions in these areas from India's point of view. 

The indirect taxation issue

The matter of indirect taxation basically pertains to customs duties that don't exist currently on electronic transmissions due to a WTO moratorium agreed by members during 1998 and which continues with extensions till date. There is a now a debate about whether the moratorium needs to be ended and countries be allowed a framework to impose customs duties on electronic transmissions. At stake is the potential revenue implications which vary in calculation, with a range that varies from 280 million USD to 8.2 Billion USD per year, and which even at the higher end appears too small to actually matter. However, few countries including India wish the moratorium to end this year after it lapses leaving the members free to impose duties on cross border data and electronic transmissions. 
There is no doubt that the consumers would be at the receiving end of any such tax/duty. But more importantly we need to analyse as to whether it would work in favour or against India. There is a successful IT and ITeS sector in India that depends on electronic transmissions. If we decide to impose tariffs on certain types of electronic transmissions, we may expect reciprocal taxes from partner countries on our types of electronic transmissions, and which might damage our competitiveness in IT/ITeS. The cost/benefit analysis therefore should go beyond mere 'revenue loss' mindset and should include the reciprocation effects. Software lobbies therefore oppose the move and present cogent arguments. Also, it's not easy to determine the methodology of taxation due to origin issues. The netflix videos that one watches on the mobile/computer/TV receives packets of data. These packets arrive from nearest possible servers which need not be located in one country. A typical HD movie might get millions of packets which may be served from eight different countries. To isolate the amount of taxation for each arrival would be methodologically complex. The complexity increases with characterisation of the data being transmitted. Some data can be called services, some can be IP and some transmissions such as designs might involve a royalty. Even if a simple methodology is developed to characterise the transmission and tax them, there are chances that firms may use routing protocols to minimise border crossings and taxes. 

India's unique placement

However, despite the above challenges, India's case is unique.  India is is one of the biggest importers of digital products using E-Transmissions as can be seen below. 
WITS database - Net exports of physical digitizable products 
The UNCTAD study has arrived at a potential revenue gain of around half a billion US dollars for India if India decides to opt out of the moratorium. The number projected as India's gain is greater than sum total of gains that might accrue to all developed countries put together if the WTO moratorium ends. Also, this number is unmatched by any other developing country and explains India's position towards ending the moratorium. 

Image of Potential revenue gain by ending WTO moratorium
Potential revenue gain by ending WTO moratorium
However, the above numbers are controversial and blamed for presenting only one side of the coin. In a paper, Hosuk-Lee and Badri Narayan argue that the potential gain through revenue collection through border taxation on these activities would get offset by the losses that would accrue to the GDP due to this taxation. They summarise the losses and gains as follows: 

GDP and Tax losses upon imposition of tariffs 
In short, they argue that a tariff gain of half a billion USD would lead to a tax loss of 2 Billion USD due to decreased GDP, decreased investment, welfare loss and loss in employment. These figures are for a scenario that the authors create where other countries reciprocate upon ending of moratorium. The authors also argue that there might be concomitant employment loss of around 12,70,000 jobs upon reciprocation. They feed in the indirect taxation into direct taxation issues of corporate profits and end up painting a bleak picture if moratorium ends. 
(On a side note, the paper feels too pessimistic to read and serves as an effective counter to the UNCTAD study.)
India needs to seriously do an independent analysis of the whole issue before pitching one way or the other. Relying solely on UNCTAD study might not be enough to take a call. 

The policy question on indirect taxation 

Therefore the correct question for policymakers in the area of indirect taxation should be: "Is it really worth to trade away the competitiveness of IT sector, employment, tax losses, and consumer welfare for a potential tariff revenue in terms of customs duty that appears so meagre to start with, and which is difficult to implement?"
The question is loaded in a way that it self-answers. But if you look at it carefully, the answer is: "It depends."

The direct taxation issue and the OECD's Unified Approach/GloBE under Pillar One/Two

Coming to the question of direct taxation, OECD, while making the final report in the matter of  'Addressing the tax challenges of digital economy' during 2015 stated that "because the digital economy is increasingly becoming the economy itself, it would not be feasible to ring-fence the digital economy from the rest of the economy for tax purposes." 
From that conservative view in 2015, OECD evolved its way through the interim report on the matter in 2018 and finally a policy note in early 2019 which in turn evolved into full discussions leading to a  public consultation document titled "Secretariat proposal for a 'unified approach' under Pillar One" during Oct-Nov 2019. Under this document,  the matter of taxing digital multinationals has been pried open with the idea of taxing them based on location of revenue generating users over the earlier principle of place of physical presence of business. This will disrupt the existing tax position and settled way of working for Amazons and Facebooks. 

Chiefly, the issues being dealt by OECD under Pillar One are: 
  • the allocation of taxing rights between jurisdictions; 
  • fundamental features of the international tax system, such as the traditional notions of permanent establishment and the applicability of the arm’s length principle; 
  • the future of multilateral tax co-operation; 
  • the prevention of aggressive unilateral measures; 
  • the intense political pressure to tax highly digitalised multinationals. 

The discussion hovers around:
  • reallocation of taxing rights in favour of users/market jurisdiction over the existing principal location of business for highly digitised businesses
  • The nexus rule that would be independent of physical presence in users/market jurisdiction
  • going beyond arms length principle currently in practice for related entities across borders

The matter is work in progress. 
However, what's noteworthy is that the three corner positions on Pillar One are clear. The first corner is of US which wants taxation based on market intangibles, the second corner belongs to France and EU which wants taxation based on user participation, and the third corner belongs to India which wants the new nexus principle wherein level of physical presence is ignored in favour of amount of business generated in a tax jurisdiction. The negotiations shall evolve over time and the three corners should reach a consensus point wherein a final unified approach evolves and agreed by all. 

The Pillar Two pertains to Global Anti Base Erosion Proposal (twisted to fit the short-form: GloBE) wherein rules are being discussed to avoid multinationals in digital economy from shifting bases and profits. This is a purely a taxation matter. 

Both WTO and OECD matters are coming to an inflection point with vigorous debates/discussions/activities. It would be interesting times for trade and tax policymakers while a new legal paradise gets created for lawyers. 

Dec 4, 2019

Bonded Manufacturing Scheme - The potential game changer for manufacturing sector

Government has tweaked the existing scheme of manufacturing under bond at bonded warehouses (Section 58 to 65 of Customs Act) and has come up with a 'Bonded Manufacturing Scheme' which might revolutionise the way manufacturing units are organised among domestic tariff areas, Free Trade and Warehousing Zones, Export oriented units (EOUs) and Special Economic Zones (SEZs).

The relevant customs notification (69/2019) on Manufacture and other operations at Warehouse Regulations 2019 is at this link.
Invest India (an arm of government that encourages investments in India through realtime assistance to entities to set up business) maintains a dedicated website for information dissemination on this topic at this link and the FAQs are hosted here.
Relevant Customs Circular (34/2019) that outlines the regulatory procedural details is at this link.

image for bonded manufacturing scheme
Bonded manufacturing scheme overview - [from Invest India's Bonded manufacturing website]
The salient part of this scheme is that one may import capital goods required for manufacturing without payment of import duty and use it in the factory/premises. In addition, all raw material/inputs required can also be imported duty free for manufacturing. If one exports, no duty needs to be paid on anything that was imported. Only if the finished goods are being cleared out of bonded manufacturing zone and into the local market, duties on inputs to the extent of consumption for the cleared products to domestic market needs to be paid. Also, there is no hassle or requirement of any net foreign exchange earning, or any need to export in order to fulfil some obligation against procurement of duty free capital goods, inputs etc.  This is good enough for most of the existing and new industries to move into this new scheme being promoted by Invest India group of Department of Industry and Internal Trade (DPIIT). You get imported capital goods for free, and pay duty on imported raw material/inputs only when you clear them to DTA, thus deferring the duties till you actually sell the products. Even for import, stock and trade business model (say an e-commerce company which imports and sells here), this model makes sense as duties are to be paid only upon sale. Upon non-sale the goods can be returned back. Only if inputs are procured from domestic market, GST is applicable (and credit taken) and which I shall deal later in the post.

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Advertised advantages of bonded warehousing
The advertised highlights of the scheme propagates the advantage of 'no fixed export obligation' and 'deferred duty' aspect.

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Ease of doing business through bonded manufacturing scheme
The scheme also emphasises upon the procedural ease of doing business at bonded manufacturing zones.
While not stated in the website, the circular amply makes it clear that the intention is indeed ease of doing business and therefore no prior permission of proper officer is needed for clearing the goods each time. Also, self sealing facility of goods while clearing has been allowed. Therefore, a lot of trust has been reposed on the operating business.

What are the potential downsides?

- The zone is administered under Customs Act, and therefore the zone will be under total control of customs commissioner with the commissioner (or the designated officer under him) being the sole approving person, and point of contact for  business. Many domestic firms, especially smaller ones, might not be very comfortable with the idea due to legacy reputation of customs department.

- The Annexure B format that covers incoming and outgoing goods, along with details records of consumption, is tedious to maintain. The ERP system of the firm moving into bonded zones needs to be tweaked to align with this format as any error here would lead to serious issues. Maintaining these records digitally by inputting the details manually (say with a poorly designed excel sheet without cross checks) would be a dangerous assignment as any mismatch might attract penal actions. The Annexure is to be maintained digitally as per the notification.

Policy analysis 

The positives:

As a policy measure towards ease of doing business in India, nothing beats this scheme on paper. The EOU scheme (including EHTP, BTP etc) would become defunct, given all the license era obligations of Net Foreign Exchange earnings, limited clearance to domestic tariff areas etc.
SEZ policy too would be challenged as new units may reconsider bonding under this scheme over locating into SEZs.
The Foreign Trade Policy chapters 4 and 5, wherein exemptions of duties under Advance Authorisation(AA) Scheme and Export Promotion Capital Goods (EPCG) schemes are granted for procuring raw material/inputs and capital goods respectively, would also be rendered useless when units move to bonded manufacturing scheme. In fact, with no obligations on duty free import of capital goods, there is no reason now to go under EPCG scheme for any new units being set up. EPCG calls for myriad rules and obligations for exports whereas it's much simpler under bonded zone. It also frees the units from the standard input output norms which at times are tedious to align for new products and take time for fixing of such norms as the process involves the unit, local DGFT office, and DGFT headquarters at New Delhi. Under bonded zones, the input output norms are to be self declared, and any revision of the same has to be simply notified to the jurisdictional bond officer. As long as accounts are maintained, trust is reposed on the units to comply.
The scheme, as it doesn't link exemptions to any export performance, and being made available to all, is WTO compliant in nature.

The negative: 

The scheme disadvantages domestic manufacturers of capital goods and inputs as no exemption has been given to domestic suppliers for supply to these units. GST is applicable to supplies made to the bonded zones and credits may be availed against the same which may later be used when the bonded units supply goods to domestic market. However, not having an upfront exemption would tilt the choice towards imports, assuming all other conditions being same. This goes against 'make-in-India' spirit of the policymakers.


Overall, it's an excellent step as it gives a practical option for investors trying to set up new units. When read in tandem with the reduced corporate tax rate (from 25 to 15% for new units), this move may indeed attract investments into India. It also makes sense for existing units who are thinking of procuring imported capital goods in a significant number to get bonded under the scheme.

The scheme deserves to be advertised widely for better information dissemination.

May 12, 2019

The interest in free trade and related matters - a silent story from google trends

Google web-search is a rough indicator of the hotness/popularity of the topic.
Here's what you get for some of the words that this blog cares about, if you see the popularity trend in Google web searches across the world over last 15 years.

1. Free Trade

2. WTO
3. Free trade agreements

4. Tariff Barrier

5. Non Tariff Barrier

6. Trade war

7. International Trade

8. E Commerce 

Mar 24, 2019

MSMEs in cross border E Commerce – Challenges, Opportunities and Trade Facilitation Measures

MSME's and E Commerce

MSMEs currently contribute to around 40% of exports of India. E-Commerce is an area that has shown tremendous potential for growth, especially for MSMEs. It is so because MSMEs suffer from certain handicaps in traditional trade models, with regard to access and scale, that are ameliorated in an E-Commerce model. This post shall elaborate some of the challenges and opportunities that pertain specifically to MSMEs when it comes to E-Commerce trade across border before deliberating on the facilitation measures specific to MSMEs.

Data from Statista show that retail E commerce trade will grow to around 4.8 Trillion USD by 2021 – around two years from now. Around 30% of this is expected to be cross border trade through E-Commerce route. Data also shows that 82% of enterprises involved in such cross border trade are micro and small scale in size (definition of SMEs vary across countries/organisations). 

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Opportunities for MSMEs in Ecommerce

E commerce creates opportunities for MSMEs through 
a)     Easier Outreach potential 
b)    Easier Market Research
c)     Easier Reputation building
d)    Easier Marketing expenditures
e)    Development of ecosystems creating synergy

E Commerce brings a paradigm shift in terms of dealing in delivery time, warehousing concepts, customized production and social marketing. The traditional model of value chains are being broken up – for example, the evolution of shipping from bulk cargo to containers of last four decades is giving way to, what one may call, "parcelization" (there’s no such word as of now in the dictionary) where individual parcels - recall the amazon box parcel you got last time around – play the role of a unit of measure in transport cargo.   

Challenges for MSMEs in E-Commerce

The efficiency of logistics and cross border procedures are yet to catch up with the blazing speed with which E Commerce has grown. The volumes of E Commerce shipments are straining the existing logistics industry and associated business costs. 

E Commerce is also challenging border regulatory agencies and they have not evolved sufficiently fast to cater to the emergence of E Commerce. The customs operates with laws made decades ago with a priority on border controls and emphasis on duty collection over trade facilitation. 

Five types of trade costs associated for MSMEs in particular that challenge the faster growth of cross border E Commerce trade are: 

a)     Tariffs and duties
b)    Technical barrier to trade – standards that are rigged against SMEs
c)     Documentation requirements
d)    Border costs – fee/charges associated with border crossing
e)    Logistics costs – transport, insurance and warehousing costs 

The cost of delay at border clearances add up to the detriment of MSMEs, squeezing their competitiveness. 

Vulnerability of MSMEs in international trade

The vulnerabilities arise due to the fact that MSME's 

a)     Need more human resource to export per unit of revenue due to scale of operations 
b)  They Have limited access to financing and costlier financing when compared to bigger corporations with better access to credit. 
c)     MSMEs trades are usually categorized under high risk items under Risk Management Systems and are subject to greater border controls 
d)    MSMEs usually cannot afford high quality logistics operators to handle their shipment leading to sub-par performance on logistics front. 
e)    MSMEs usually export small volumes of low value added products leading to longer breakeven times for the firms. 

Trade Facilitation Measures for MSMEs in Ecommerce

Trade facilitation Measures should focus on MSME's needs if India wishes to grow in this area. The bigger multinational organisations have their in-house teams to manage supply chains and optimise the operations. Giant firms operate efficiently, optimise logistics, and involve themselves with policymakers to ensure that the border policies don't harass them. The bulk of these organisations ensure that Governments heed to their demands in the interest of earnings and employments that these firms bring to the country. That's not so when it comes to MSMEs. That's where forming associations for protecting interest of MSMEs become important. Without an association or representative body, it is difficult to hear the voices of MSMEs. 

Many countries approach the trade facilitation to SMEs through a system of de-minimis where customs duties are not levied for products with value less than a certain threshold. This encourages trade while sparing disproportionate efforts by customs in collecting what in the end adds up to a relatively small percentage of revenue. India has granted certain easier tax processing and compliances for small scale industries through the composition scheme. However, for inter state and export transactions, SMEs still don't enjoy sufficient freedom. While tax evasion is certainly an issue from revenue loss point of view, but if the revenue arm enjoys overbearing say in the area of taxation of SMEs, we may end up stifling growth. While the SMEs grow, it is better to let a small bit of revenue slip in the interest of higher employment and prosperity. This, alas, is an approach that appears lost in the din for maximisation of revenue in India. 

Also, schemes that are designed for greater ease of transaction at border, such as the Authorized Economic Operator (AEO) program - a program flowing from the Trade Facilitation Agreement of WTO -  are heavily skewed to help multinationals and bigger corporations. A rethink is required to make such programs suitable to MSMEs. 

Finally, the barriers to trade for MSMEs arising out of technical and non-technical barriers erected by various governments needs a look into. As world have negotiated away the tariffs, a common way to protect local industries is through erection of the so called Non Tariff Barriers (NTBs). The rise of NTBs in recent years has affected MSMEs badly. This has carried over to the E-commerce trade. 

To sum up, trade facilitation for MSMEs needs a paradigm shift in the way the border compliances and regulatory functions are designed. Unless addressed adequately, we may end up in a situation where the bigger organisations end up gaming the cross border E Commerce and leading to an unequal, non level playing field for SMEs.