India’s trade policy folly: Current turn to import substitution will take economy down from turnpike to dirt road

by Arvind Panagariya

Trade openness today faces both external and internal challenges in India. Externally, tariff hikes on aluminium and steel imports by the United States invited retaliation by us, at least as a last resort. We also face challenges of secondary sanctions arising out of the US sanctions against Iran and Russia. Internally, bureaucratic forces have regrouped to return India to import substitution.
This column is exclusively about the latter, internal challenge. Despite repeated assertions that ‘Make in India’ is about making for the world, in reality, it is the ‘Make in India for India’ view that is winning. The first significant tilt in this direction came with the extensive tariff hikes in the 2018-19 budget, which the revenue secretary later defended as necessary to promote import substitution. True to his word, he went on to deliver additional tariffs subsequently.
To top it all, we have now appointed a taskforce headed by the cabinet secretaryaimed at cutting imports of items that India can produce at home. It may be recalled that the key elements of our 1991 reforms were end to import licensing on all products other than consumer goods, two back-to-back devaluations of the rupee, end to investment licensing and opening to foreign investment. During the subsequent two decades, the process of import liberalisation was deepened with complete dismantling of import licensing regime in 2001 and a decline in the average industrial tariff from 113% in 1990-91 to 12% in 2007-08.
That liberalisation brought us handsome rewards. Between 2003-04 and 2011-12, India’s GDP grew 8.2% annually leading to massive fall in poverty. Alongside, imports of goods and services expanded from $85 billion in 2002 to $642 billion in 2011-12. The expansion of exports and remittances from $92 billion to $518 billion over the same period helped sustain these imports.

What was the connection between rapid growth in the GDP and the expansion of imports and exports? As we liberalised trade, we produced and exported more and more of those products for which our production costs were lower than our trading partners and imported more and more of the products for which our production costs were higher. To use the economist’s jargon, we specialised in and exported products in which we enjoyed comparative advantage and imported products in which we lacked comparative advantage.

 

This same explanation also goes a long way (though it is not the whole story) towards explaining why our performance was so abysmal during the first three and a half decades after Independence. During those decades, we kept tightening our import regime more and more and pushing the economy into producing goods in which we lacked comparative advantage.


Sadly, our current turn to import substitution threatens to return us from the turnpike on which we have been travelling all these years on to the dirt road. To be sure, with imports and exports of goods and services at 21.6% and 19.6% of the GDP respectively in 2016-17, we are far more open today than in the 1950s when we first experimented with import substitution. For this reason and because response to any policy change takes time, we will not feel the impact of our mistake immediately. But if we stay the current course, we will eventually find ourselves on the dirt road. Then, no matter how powerful the engine of our vehicle, we will slow down.


There is no wisdom in producing at home products that we can buy abroad at lower cost using our export earnings. It is best to let a doctor do what he does the best and nuclear scientist do what she does the best. It is a trap to think that the doctor can also do what the nuclear scientist does and vice versa. The same principle applies to nations.


Rather than appoint a taskforce to find ways to curb imports, our strategy should be to appoint a taskforce to devise strategies to expand exports and to do so on a war footing. That is precisely what President Park Chung-hee – who made South Korea what it is today – did. After he embarked upon an export-oriented strategy, he personally presided over many hundred meetings each year to ensure that bottlenecks facing exporters were promptly removed. In less than a decade, Korea’s exports rose from just 3.5% of the GDP in 1963 to 21.3% in 1972. And Korea grew 9.5% annually during that same decade.


Mathematician and nuclear physicist Stanislaw Ulam once teased economics Nobel laureate Paul Samuelson, asking whether he could name “one proposition in all of the social sciences which is both true and non-trivial.” Samuelson was dumbfounded at the time, but later wrote that his answer should have been the principle of comparative advantage. “That it is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.”


No wonder, generation after generation of bureaucrats has tried to defy this immutable principle and time and again produced outcomes that only go to prove its truth.