Modi's plans to reform India hinge on one aspect: Free trade
Economic Times, August 16 2020
Since the second United Progressive Alliance (UPA) government, India has come a long way on the road to reforms. Insolvency and Bankruptcy Act (IBC), Goods and Services Tax (GST), Direct benefit Transfers (DBT), National Medical Commission (NMC) Act, Ayushman Bharat, slashing of corporate profit tax, commercial mining in coal and agricultural marketing reforms are some key examples. The pipeline of reforms to come includes such major measures as the National Higher Education Commission Act, public enterprise policy, and electricity reforms.
Sadly, however, the scope of benefits of these reforms is being considerably limited by our policy mistakes in one important area: international trade. Here we are deviating from the road of steady liberalization that we had adopted in 1991. We traveled on this road till 2007, stopped, and have now taken a U-turn to begin traveling in the reverse direction.
I have no doubt that eventually India will transform itself into a modern urban industrial economy. The critical question is whether we want to do it in 100 years or more as nearly all western industrial economies did or in two to three decades, as the economies of East Asia have done? If the latter, we need to reconsider our trade policy.
Empirically speaking, there is no country that has achieved rapid transformation by being inward-looking as opposed to outward oriented. Governments of rapid transformers may have intervened here and there but the broad fact remains that those interventions did not interfere with their expanding trade in any substantive way. Moreover, those interventions slowed down rather than accelerate growth. I have documented these trends at length in my recent book Free Trade and Prosperity.
A key advantage of maintaining an open trade regime is that it benchmarks our firms against the best in the world. A commitment to openness forces us to ask what changes to domestic policies must we make to remove the disabilities that handicap our firms vis-à-vis the best in the world. But when we give up openness and use import protection to help our firms withstand foreign competition, we are not addressing the fundamental source of the disability. Such a policy may enable our firms to compete in the domestic market but, with fundamental sources of disability left unaddressed, it will not make them competitive in the global economy.
Import protection as the path to global competitiveness is a non-starter. We need look no further than our own auto industry that punishes our consumers and, despite prohibitive wall of protection for 70 year, remains dependent on the same crutches.
The reason why import substitution looks so attractive to many is that they only see what is visible to the naked eye: the addition of output in the protected sector. They do not see what requires deeper vision: output subtraction in other sectors. One simple way to see the subtracted output is to recognize that a nation’s resources at any point in time are limited. When a protected sector such as auto expands, it takes away resources from other sectors. Its expansion is not a positive-sum activity.
Even more concretely, take the volume of investible resources available at any point in time. By definition, these are given by the nation’s own savings plus the current account deficit. The latter determines the volume by which foreign capital complements domestic savings. With the domestic savings rate a given and the current account deficit held at some target level (often 1 to 2% of the GDP) by the Reserve Bank of India, the total investible resources in any year are fixed. Therefore, if protection allows auto industry to expand by investing more, it leaves less investible resources for some other sectors. There is no free lunch.
An alternative way to see the same point is that the Reserve Bank of India manages the exchange rate to maintain the current account deficit at some target level. Therefore, any effort to curtail the imports of one product through import substitution would either expand imports of another set of products or contract exports.
Once we recognize that the notion that we can add to GDP by simply replacing imports by domestic output is a fallacy, we can come back to look at productivity effects of import substitution versus export orientation. Import substitution typically attracts inefficient firms by creating quick rents. Domestic firms that enter the market have no plans to eventually capture the world markets. They see an assured, almost risk-free market behind protective wall. Our own experience in electronics industry in the past six years illustrates this point. During this period, not a single domestic firm that promises to turn into an export powerhouse has entered the market. And the pace of expansion this sector has shown even inclusive of foreign multinationals places us closer to the time-path followed by western industrial nations rather than East Asian ones.
If we want to capitalize on the vast benefits our numerous reforms promise, it is critical that we do course correction on trade policy. To use an analogy from our favorite sport, could we have produced the long stream of world-class cricket players such as Sachin Tendulkar, Virat Kohli, Yuvraj Singh, Saurav Ganguli and recently retired M. S. Dhoni without playing test cricket? The same goes for world-class firms.