Jul 2, 2013

Simple and dangerous ideas to reduce Trade Deficit

India's current account deficit(CAD) is hovering at uncomfortable levels, despite an improvement shown in data released last week. The merchandise trade deficit is around the range of 200 Billion USD annually, which contributes major portion to the CAD. The gap is managed by capital flows and trade in services. 

At such times, it is common to hear ideas to control trade deficit, and in turn, CAD.  I totally endorse those ideas that talk about deeper reforms and focus on issues such as infrastructure (power, ports, roads etc) and capacity building of institutions (financial, executive, judicial, regulatory etc). I also agree with ideas on measures that control inflation and talk about fiscal prudence and tax reforms. Lack of deeper reforms, irresponsible fiscal policies and inflation is at the heart of today's CAD. In this post, I am going to talk about ideas other than these. Most of such 'other' ideas aim at import control, directly or indirectly. Such suggestions not only indicate dim understanding of international economics and trade, but also of history, especially of the times between first and second world wars when trade restrictions exacerbated the recovery of economies. 

The simplest of such ideas is to ban imports. If not ban all, then at-least non-essential imports such as luxury goods, Gold, toys etc. When it is pointed out that it is no longer permitted in globalized, WTO regulated world, the common retort is to suggest imposing quotas or tariffs on such goods. The rationale is that such high tariffs or quotas will limit the imports, while not hurting our exports. Sometimes poeple use quotas and tariffs interchangeably while arguing their case. There is difference in tariff and quota, as you can see in this post, but for now, let's assume that tariffs can have the same effect as quota, in decreasing imports, which is generally true.

The problem also lies with the definition of non-essential goods. If one takes out Capital/Engineering goods, Petroleum products, Gems and jewels (as they are used in exports in turn), chemicals, pharma products and so on, we are left with only consumer electronics of certain types (smartphones, tablets, gizmos and such), imported luxury automobiles, toys and such that can be called non-essential. All these hardly add up to 20 Billion USD of imports in a a total of around 480 Billion USD of imports of India. You can see exact figures here. If we add Gold and Silver to it, we will get a respectable figure of around 80 Billion USD for control purposes. I am not sure if all Indians would agree to put Gold under non-essential imports, but let's assume so for the time being. 

The question is, how high a tariff would seriously decrease these imports. The answer is, it depends on the product's demand curve. The above products are generally price inelastic. A small hike might not stop an iPhone buyer from shelling out an extra 1000 rupees, nor would it deter a gold buyer from buying gold for marriage/savings. So the tariff increase has to be large. A large increase would now incentivize smugglers and duty evaders and Burma bazaars would thrive. Also, it would immediately attract retaliation from other WTO members, who might drag us to dispute panel at WTO, and simultaneously erect their own barriers  against our exports.  In addition, any such measure would be read by foreign investors as a sign of panic, and probable balance of payment crisis, leading to withdrawal of funds from India. Future investments would also come under question in a regime with lack of certainty of foreign trade policy. 

Assuming that the above import restriction manages to decrease targeted imports by 40%, we would save 32 Billion USD. However, the retaliation from other nations might bring down our exports by same number. Also the capital outflows might reduce the margin further. Of course, the last one might depreciate rupee further, leading to better exports in the long run, but in the short run, we will end up with worse CAD and potentially stare at default if things go seriously wrong. Economists are well aware of the J curve effect of currency depreciation in short run. The currency depreciation affecting balance of trade is given by Marshall-Lerner condition, which puts the weight on elasticity of import and export products. In a global economy of low demand, a price decrease of export products might not have intended effect, leading to inelastic behavior in exports. Also, we have an inelastic import basket in petroleum, gold etc. So our trade balance would deteriorate. Also, it is not that we export only to US against whom our currency has depreciated. Other currencies have also depreciated against USD recently and to expect our exports to pick up with countries other than US, due to currency depreciation is moot. 

The same would be the effect if we try to erect quotas. Also, quotas have this bad habit of benefiting the quota-grabbers, at the cost of govt revenue that tariff would have generated, unless quotas are rented out for revenue. This arrangement would be complex, retrograde, and might lead to scams in country like ours. 

Some might also propose that non-essential imports should be allowed only against a quota. The quota mechanism of the proposal was interesting. We might give some kind of import-license to exporters, commensurate to their export performance, as an incentive. This will be the allocated quota. The non-essential goods can be imported only against this quota. Exporters, in turn, would sell their quota in open market (or use it themselves) to importers who wish to import non-essential goods. When they sell it, they might do so for a premium. This would have two effects. First, it would act as an incentive for exporters, and second, it would act as an additional cost for importers of non-essential goods. So our exports will be boosted at the cost of imports. Though the idea looks attractive on the face due to the complexity of the mechanism involved, a closer reading would show that it suffers from the same pitfalls of an increased tariff. Retaliation, WTO disputes, market sentiment, and capital outflows apart, one can mathematically show that such ideas would hardly generate much change in the trade deficit given the nature of elasticity involved. In fact, there are very few studies linking export performance with incentives. In case of Gold, it is the seasonal fluctuations that play a major role and increasing tariffs hardly affect the imports. Also, a high tariff in gold will restart smuggling activities of 1980s. So, we go back to our argument in the previous paragraphs that this idea too is no good.

It is not that one finds such ideas only here. Whenever a country faces difficulty, such ideas fly. US had its own protection related act during great depression where it increased tariffs on imports on over 20000 items. You can read more about it, here. However, it's difficult to enact such things today due to WTO. You can see how concerned WTO/UNCTAD sounds about the trade protectionist measures that has risen recently, here.

I hope this post helps put few things in perspective for import control ideas.