Economic openness is necessary but not sufficient: it succeeds only when combined with strategic industrial policy
The third summit of the Regional Comprehensive Economic Partnership (RCEP) held in Bangkok, which concluded this week, sought to finalize a mega free-trade agreement among 16 countries from Asia and Oceania, which are home to one-half of the world’s population and account for about 40% of the world’s gross domestic product (GDP) and trade.
The quest for RCEP was driven by two objectives. For one, each participating country hoped to capture the benefits of regional cooperation through deeper economic integration. For another, it was a strategic geopolitical attempt to create a bloc with a voice and influence in the world. However, the process of plurilateral negotiations, which began in 2012, between countries that are diverse in terms of economic size, income levels and national interests, was inevitably complex. The prolonged uncertainty ended when Prime Minister Narendra Modi announced India’s decision not to join the group, and RCEP was born with only 15 member-countries.
In this context, it is important to note that India already has free-trade agreements with Asean since 2009, South Korea since 2009, and Japan since 2011. In addition, RCEP includes China, Australia, and New Zealand. The experience since then has been instructive. Between 2014-15 and 2018-19, India’s trade deficit increased from $13 billion to $22 billion with Asean, from $9 billion to $12 billion with South Korea, and from $5 billion to $8 billion with Japan. Obviously, these agreements led to a far greater increase in imports than in exports. In fact, India’s exports to these markets witnessed a stagnation, just as its total exports did.
Over the same period, India’s trade deficit with China rose from $48 billion to $54 billion, while that with Australia and New Zealand went up from $8 billion to $9 billion. Thus, in 2018-19, India’s trade deficit with its potential RCEP partners alone was $105 billion, which was larger than its total trade deficit of $104 billion with the world as a whole, which included imports of crude oil and petroleum.
It is no surprise that there was massive resistance to the idea of joining RCEP across sectors in India, most of which are vulnerable to the import surges that could and might follow a RCEP kind of free-trade agreement. This is obvious in the manufacturing sector, which has been hurt by imports of goods from China, so much so that deindustrialization is discernible. The problem would certainly have been exacerbated by joining RCEP, as rules-of-origin can be easily circumvented and Chinese goods could have been routed through other member countries.
The agricultural sector, which is protected by tariffs in the range 30-40%, could have been even more vulnerable. The plantations sector, particularly in Kerala, would also have been at risk. India might be the largest producer of milk in the world, but its tiny dairy farms simply could not have competed with scale-economies and superior-technologies of the dairy industry in Australia and New Zealand. The story would have been similar for mining. Output and employment would have been the casualties. Such fears led to a chorus of protests, which could not be ignored by an elected government in a political democracy.
Government negotiators bargained for safeguards that would protect the domestic industry from import surges and also for provisions for market access in services that could be competitive. This was not forthcoming. Under the circumstances, it was both necessary and desirable to opt out of the free-trade agreement.
However, the government was wrong in its belief that the pact would have been more balanced if there were some compensation in services and investment. India does have a comparative advantage in software exports, but that is not true of business services, financial services or telecommunication services, where other RCEP countries, such as Japan, South Korea, Singapore, and China, are far ahead. Much the same could be said about investment. Such agreements on services and investment can seriously constrain the policy space because they stipulate what governments can or cannot do in the sphere of domestic economic policies, unlike agreements on trade that are confined to tariffs imposed on goods that cross borders.
The government said that the decision not to join RCEP is final for now. However, the joint statement of leaders at the end of the summit and the subsequent statement of India’s commerce minister suggest that India might consider joining the agreement at a later stage, perhaps next year, if the differences are resolved. This ambiguity is a cause for concern. The desire to rush into a free-trade agreement with the US or the EU on the rebound is more worrisome.
It is essential to shut the door on RCEP and other free-trade agreements until we get our act together at home by creating an economy that is competitive in the world market. Economic openness is necessary, but not sufficient. The revival of industrialization in India requires using interest rates and the exchange rate, calibrating trade policy, influencing foreign investment to pursue national development objectives, and providing industrial finance. Strategic coordination of these policies with a long-term perspective is described as industrial policy.
This is the primary lesson that emerges from the success stories in Asia—be it Japan, South Korea, Singapore, Taiwan or, more recently, China. Economic openness was combined with strategic industrial policy that was implemented by effective governments. The advocacy of free trade by these countries came only after they succeeded at industrialization.
India must follow this path. Until then, it must do everything it can to strengthen the multilateral trading system embedded in the World Trade Organization, instead of rushing into free-trade agreements in an elusive quest for development.
Here’s why.
Historical data shows that regional partnerships haven’t proven to be very beneficial for India. In fact, over the span of six years (2014-19), among its trading partners, India has improved its trade balance only with Safta countries, as a whole. In case of Asean countries, as the alongside chart shows, India’s merchandise trade deficit has widened in this period.
Further, an analysis by ICICI Securities Ltd shows that in FY19, India registered trade deficit with 11 out of the 16 RCEP countries. India’s trade deficit with RCEP countries stood at $105 billion, out of which China alone accounted for $52 billion.
Clearly, ignoring these numbers could prove to be costly for India, which is already grappling with a fiscal deficit.
Additionally, economists point out, a key concern for India is the dumping of cheaper goods such as diary and farm products, and electronic items, especially from China. The RCEP deal format required India to abolish tariffs on more than 70% of goods from China, Australia and New Zealand, and nearly 90% goods from Japan, South Korea and Asean. This would have made imports to India, cheaper.
Now that India has made up its mind to pull out of RCEP, what does this mean for India’s exports?
Analysts at Emkay Global Financial Services Ltd say that India’s exports are much more responsive to income changes than price changes. So, a tariff reduction/elimination does not boost exports significantly. “It is tough to say whether the Indian services will benefit as China and Thailand are emerging as a new services hub for attracting FDI,” they said in a report.
Anagha Deodhar, an economist at ICICI Securities, says that given India’s size, its exit from the RCEP would greatly reduce its coverage and significance. “Although India may lose market access to Asian economies at preferential rates, its vulnerable domestic industries would be protected from intense competition and more importantly, Chinese dumping,” she said.
In short, in this ongoing battle of fixing the severe domestic demand slump, India chose not to further hurt competitiveness of its local industries. This should come as a relief, especially for small- and medium-sized enterprises.
India eventually decided to play it safe by pulling out at the last minute from the Regional Comprehensive Economic Partnership (RCEP) which was finalised by 15 countries in Bangkok on Monday. The pressure mounted on the government and the Prime Minister by interest groups, ranging from farmers, small industries and traders, to political parties across the board, surely played a major role in the decision to stay out of the grouping. The country had little choice but to exit after its safeguard requests were not conceded. On the one side was the looming figure of China in the group and that country’s desperate need to find newer markets for its products in the backdrop of its trade dispute with the U.S. That India runs a massive bilateral trade deficit of $53 billion with China and the fact that China has not taken satisfactory efforts to whittle down the deficit certainly were major inputs in India’s decision. Second, India’s experience with countries with which it has signed free trade agreements till now is not exactly a happy one. Though trade has increased post-FTA with South Korea, ASEAN and Japan, imports have risen faster than exports from India. According to a paper published by NITI Aayog, India has a bilateral trade deficit with most of the member countries of RCEP. More importantly, while exports to RCEP countries account for just 15% of India’s total exports, imports from RCEP countries make up 35% of the country’s total imports. Given this, it is obvious that in the immediate context the country had more to lose than gain from joining RCEP.
India’s request for country-specific tariff schedules was rejected early in the negotiations. So was its suggestion of an auto-trigger mechanism to check a sudden surge in imports from particular partner countries. India also argued for stricter rules of origin, and rightly so too, but this too failed to pass muster. Movement of professionals was another area that saw an impasse. Given these, there was little chance of the political leadership agreeing to join the bloc. Policymakers must have reasoned that India has active FTAs with most members of the RCEP except China, Australia and New Zealand and there will be no economic impact. However, the fallout of India’s decision is that it has burnished its image as a protectionist nation with high tariff walls. With a market of 1.3 billion people, there is bound to be more pressure on India to open its gates. The smart way to handle this is to initiate reforms on the export front, bring down costs in the economy and, simultaneously, increase efficiencies. India cannot miss out on being a part of global supply chains and this can happen only if tariff barriers are reduced. And the best way to balance the effect of rising imports is by promoting exports. Tariff walls cannot be permanent.