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Time to Return to Trade Reform

Arvind Panagariya

            Slowly but surely, Prime Minister Vajpayee and Finance Minister Sinha are laying to rest the doubts about their resolve to implement economic reforms.  After returning to power, their first major victory came when they successfully challenged the truckers’ strike and raised the price of diesel oil.  Soon after, they confronted head on a strike by insurance workers and enacted the insurance bill, thus, opening the sector to increased competition from domestic as well as foreign sources.  Most recently, they have begun to move decisively on the privatisation front.  In what can be termed as the first true privatisation, the government have transferred 74 percent of their stake in Modern Foods into private hands, principally the Hindustan Lever.  Even the Indian Airlines is now up for sale.  Though genuine concerns remain with respect to the manner in which this privatisation is to proceed, the mere fact that the government is willing to transfer 51% of its stake in the airlines into private hands speaks volumes for its future intentions.

            While no one can now call Mr. Sinha “Roll Back Sinha,” the minister’s image as a reformist finance minister remains deficient in one key respect: he has taken no initiative worth the mention in the area of international trade.

Trade liberalization, complemented by the removal of investment licensing, had served as the cornerstone of the Rao-Singh era reforms.  These reforms eventually delivered the unprecedented growth rate of 7.7% during 1994-97.  After Mr. Singh left office, however, successive finance ministers have only paid lip service to trade liberalization.  Mr. Sinha must break this trend by restoring momentum to trade liberalization in the forthcoming budget.

            Prior to the launching of the economic reforms in July 1991, all categories of import goods¾consumer, intermediate and capital¾were subject to licensing and other controls.  Admittedly, some capital and intermediate goods were on the so-called Open General Licensing (OGL) list but they accounted for no more than 30 percent of all imports.  And the imports of consumer goods were virtually banned.

            All goods, including those on the OGL, had to additionally cross a tariff hurdle of the Himalayan proportions.  Like the Mount Everest, the peak tariff rate stood gloriously at 400 percent.  Approximately 60 percent of the items were subject to tariff rates between 110 and 150 percent.  More than 96 percent of the items were subject to tariff rates of 60 percent or higher.

            During its first three years, the Rao government did away with licensing on virtually all capital and intermediate goods.  Custom duties were cut drastically so that by February 1994, the highest rate had come down to 65 percent.  A year later, when Mr. Singh presented his last budget, this rate came down to 50 percent.  In the same year, tariffs on capital goods were brought down to 25 percent or less and those on intermediate inputs to 40 percent or less.

            Sadly, after the Rao government left office, the momentum for trade liberalization evaporated.  Mr. Chidambaram introduced a Special Customs Duty of 2% in his maiden budget of 1996-97 without major tariff reductions.  In the 1997-98 budget, he increased this duty to 5 percent.  To offset the increase in protection, he reduced the highest rate in general to 40 percent and that applicable to intermediate inputs and capital goods to 30 and 20 percent respectively.  When Mr. Sinha presented his first budget in 1998-99, he introduced yet another duty, the Special Additional Duty (SAD), that amounted to as much as 6 percentage points for high-tariff goods.  This sent the top tariff rate above the 50 percent mark that had been achieved under the Rao-Singh regime!

            Last year, Mr. Sinha allowed Mr. Chidambaram’s   Special Customs Duty to expire, which was a step towards liberalisation.  But he also went on to substitute the existing 10 percent rate by 15 percent and to merge the rates of 20 and 25 percent into 25 percent and of 30 and 35 percent into 35 percent.  These changes increased protection.  Thus, all things considered, it is doubtful that custom duties have gone down more than 5 percentage points since the departure of the Rao-Singh government.

            The only serious liberalization on the horizon at present is with respect to consumer goods.  Since the beginning of the reform process, trade economists have urged successive governments to remove licensing from this sector thereby allowing consumers the same benefits of cheaper and higher-quality imports that businesses have enjoyed through the liberalization of capital and intermediate goods.  But in the end, it was a recent WTO dispute settlement ruling that finally forced the government’s hand in favour of consumers.  Accordingly, 1429 consumer goods items are to be taken off the licensing list starting April 2001.

            This liberalization notwithstanding, our tariffs remain excessively high.  Whereas the import-weighted average tariff in Sri Lanka has fallen to 10 percent, ours exceeds 20 percent.  Moreover, given the escalation in tariff rates according to the stage of production, the effective protection on higher stage of production is very substantial.  Our consumers pay the cost of protecting not only the inefficient domestic producers but inefficient foreign producers as well.  Why should the country pay one and a half times as much for locally produced Ford automobiles as their imported counterparts?

            Quite apart from the efficiency issue, macroeconomic forces currently at work further increase the urgency for import liberalization.  Capital inflows have been putting severe upward pressure on the value of the rupee.  The government’s ability to continue accumulating dollars is bound to run out sooner rather than later.  Unless imports are allowed to expand, this will cause the rupee to appreciate, affecting adversely the performance of the tradable goods sector.

            Above all, if we are to increase our exports to GDP ratio from its current level of 10 percent to 20 percent, import liberalization is inescapable.

Economic Times, February 23, 2000