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Monday, September 15, 2003

Crisil's Abheek Barua looks at the macro advantages of trade and an open economy:

India's domestic macroeconomic gains from trade and investments have become quite visible over the last three or four years. The case for a more participative long-term stance for India in the WTO would perhaps get a leg-up if these macroeconomic payoffs were highlighted more often.

What are these gains? The first and perhaps the most tangible pay-off from opening up has been tamer domestic inflation. Much of the drop in average inflation levels from 8-9 per cent just a few years ago to the current average of 3-4 per cent stems from greater integration with the global economic system. This claim needs some elaboration. The bulk of the decline in the overall inflation rate stems from a drop in manufacturing inflation (averaging just 3.6 per cent in the last 12 months). If one looks at its spread across sectors, the largest declines in inflation rates (or even negative inflation) has been in two categories. The first category includes sectors that have seen the largest inflows of foreign direct investment and consequently have the largest foreign market shares. Consumer durables are the classic example. In colour televisions, for instance, the market share of foreign entrants rose from zero in 1994-95 to 31 per cent in 2000-01. Prices of CTVs actually dropped 4.5 per cent on an average each year in this period. Thus, opening up the economy has increased competition in these industries and has whittled down excess pricing power in the hands of domestic incumbents. Lower inflation has been the corollary.

The second category of products that have seen a large drop in inflation is where opening up has led to 'contestability' or simply the threat of entry. Most commodity sectors like man-made fibres or plastics fall in this slot. These are goods for which quantitative import restrictions were removed the earliest and cuts in import tariffs were the sharpest. Inflation in these industry groups has been dampened through a two-stage process, both related to freer trade. The removal of quantitative restrictions has meant that domestic prices have become aligned with international prices, the only wedge between them being driven by the import duty. Thus in any sector where quantitative restrictions were removed, there is no evidence of sustained deviation of domestic prices from landed cost (defined as international price plus import tariff). The second stage of the process has come from a cut in tariffs. Thus, not only have local prices aligned themselves with international prices in terms of direction, but also with a cut in tariff, local prices have moved down and closer to international prices. Sharper the cut, the greater has been the equalisation with global price. The result has been a drop in local inflation.

The second tangible gain from transacting more with the international economy should be clear in the wake of the current industrial recovery. In 2002-03, the first year of the current upswing, GDP grew by roughly Rs 163,000 crore Rs 1,630 billion). In the same year, exports grew by Rs 41,112 crore (Rs 411.12 billion). That is, about 25 per cent of the incremental output in that year was absorbed by exports. The bottom line is that exports can no longer be dismissed as a peripheral activity. It is an important contributor to aggregate demand and can be a powerful engine of growth if India is to get on a long-term trajectory of 7 per cent GDP growth or more. There is a critical advantage for India that other Asian economies (barring China) do not have when it comes to exports. The large size of India's domestic market provides a buffer against a downturn in the export cycle. To put it in simple terms, the large domestic market ensures that the downside in case of a global down-cycle is a growth rate of 5 per cent in GDP, not contraction.

However, just tinkering with the exchange rate or giving a few sops to exporters is unlikely to ramp exports up by the kind of scale that a seven per cent growth entails. A rise in domestic productivity and enhanced market access are critical. Both follow from greater opening up and integration. If trade and integration do lead to tangible domestic gains, how much are current levels of trade below the 'best case' or the optimum? A way to answer this question (and thus define an optimum) is to benchmark India against other Asian economies.

This has to be done through a model that makes the necessary adjustments for the size of the exporting and importing economies, distance with trading partners etc. Crisil's 'gravity' model of nine Asian markets does precisely this. It concludes that our 'optimal' trade (that is if we were trading as intensely as our Asian cohorts) volume with our top 30 trading partners is $ 240 bn -- our actual trade with them in 2002-03 was just $ 70 bn. Can we get to this optimum by bypassing the WTO process? The answer is a categorical 'no', essentially for two reasons. The current trend internationally is towards regionalism and bilateralism largely through the mechanism of preferential agreements or trade-blocs. These are the exclusive clubs like the NAFTA in North America, MERCOSUR in Latin America or the Asean in Asia whose members give each other all kinds of concessions like preferential access and lower tariffs.

At last count there were roughly about 250 such preferential agreements. India unfortunately is not a member of any significant bloc, nor is it likely to align itself with a major bloc in the near future. Its survival in the international trading arena depends on its ability to push a multilateral line. The second role of the WTO in India's trade policy is to enable the government to 'sell' trade and investment related reforms to its domestic constituency. Past experience clearly shows that any significant reform in India, or for that matter, any developing economy needs an external trigger. India finds itself in the somewhat ironic situation of having run out of the possibility of external crises, given its vast forex reserves and a stable domestic situation. If the Indian political establishment is interested in pushing through trade and investment reform, it can use the need to comply with the WTO to make its case. This is exactly the tack China followed to keep its reform programme on track. The Indian economy could be better off if our policy makers took China's cue.
Source: Rediff.com

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