Even if one accepts that nominal protection implies greater effective protection, it is also true that trade theory indicates that, by and large, trade must be balanced over any reasonable period of time.
When applied to all countries taken together, this implies that no country should be running large and growing trade deficits or surpluses.
By Manoj Pant Over the last few months, a number of media articles have implied that India’s trade policy is becoming increasingly protectionist. The argument seems to be largely centred around reports on increase in nominal customs duties, mostly in the areas of electronics. However, before one labels a whole policy as ‘protectionist’, it is important to note that in today’s world nominal tariffs may have no relation to trade protectionism and, in fact, many of the assumptions behind the efficacy of free trade may be invalid.
First, consider the argument that an increase in nominal tariffs implies that a country is becoming more and more protectionist. This is not always true. For one, the traditional concept of free trade as the optimal policy assumes that all traded commodities are meant for final consumption. The reality is completely different. In fact, 70-80% of merchandise trade today is of trade in intermediate products: the so-called intra-industry rate (IIT). Here, countries are exchanging one kind of input (for example, steel rods) for another kind of input (for example, steel plates) in order to assemble products like cars at various points of consumption.
The only way to measure protection is by seeing if the effective rate of protection (ERP) is increasing or decreasing. The ERP is a measure of the value added in the production of any traded commodity. This implies that a commodity could be protected by increasing the duty on the goods (for example, computers) or by reducing duties on some inputs like computer parts, computer chips, casings, etc.
Evidence also shows that over a long period till about 2015 or so, while nominal tariffs were increasing, the ERP actually declined. In fact, many empirical studies now show that countries are moving towards use of non-tariff barriers (NTBs) like standards in phytosanitary specifications, environmental standards, etc, in regulating commodity trade.
Even if one accepts that nominal protection implies greater effective protection, it is also true that trade theory indicates that, by and large, trade must be balanced over any reasonable period of time. The traditional theory of superiority of free trade rests on the assumption that trade should be balanced or sustainable. The logic is simple. If I am importing a component to produce a commodity for export then, by and large, I should be able to pay for it via my export earnings. When applied to all countries taken together, this implies that no country should be running large and growing trade deficits or surpluses.
Particularly, in the last decade or two, this assumption is clearly unfounded. China is a case in point. In reality, all trade deficits (including trade in merchandise goods and services) are financed by capital imports. Since capital import implies a sale of assets to another country, the intuitive parallel is one of selling one’s house to pay for one’s present consumption! Over the long term, this is clearly unsustainable.
A third factor in assessing protectionism, particularly after 2008, is the issue of ‘structural adjustments’. As world trade expands and countries produce according to their competitive advantage, production structures in countries will have to change. For example, while in the 1970s and the 1980s, the US was a major producer of textiles, steel and automobiles, this is no longer true. Today, Pittsburgh is better known for its services sector than for steel and Chicago for its commodity exchanges than automobiles. Again, in India, apparel and textiles constituted about 23% of exports at the start of this century, but less than 13% today. The typical assumption in trade theory is that someone (the state or ‘planner’) will ensure smoothness of adjustments without a tremendous loss of livelihood when some sectors contract and others expand.
While developed countries have managed this on the basis of a well-established system of unemployment benefits, this is not true in countries like India where about 40% of exports used to come from the MSME sector which has been hit by not only structural adjustments over time but also by the pain of adjusting to trade disruptions due to the Covid-19 pandemic. A democracy will not tolerate such long, consistent disruptions. A reskilling programme is essential and the market is unlikely to provide this.
The Great Depression of the 1930s was also preceded by tariff protectionism by then-leading countries like the UK and Japan. The objective of establishing the twin institutions of the World Bank and the International Monetary Fund, along with the trade-related GATT (General Agreement on Tariffs and Trade), was to prevent tariff wars of the 1930s and ease structural adjustment. Free trade flourished from 1950 till 1980, and in the period from 1990 till about 2008, despite some glitches in some parts of the world.
However, since 2008, the expansion in world merchandise trade has come to an end and countries are looking for alternatives to tariff protection to preserve their democracies. The picture gets complicated by the replacement of manufacturing by services as a prime mover of global commerce. Services, in particular, are not regulated by tariffs but by internal policies of countries.
The World Trade Organisation (WTO) glossed over the issue of regulating trade in services by consigning it to a ‘positive list’, which implies that no country had to commit to any possible structural adjustment as a consequence of expanded services trade. Since 2008 plurilateral trade negotiations are muddling through this issue.
In other words, the free trade system initiated at the GATT and cemented at the WTO is facing the uphill task of regulating a system where the nature of the commodities traded and the actors involved in trading have changed dramatically over the last 50 years. In assessing India’s (and global) trade policy, it is critical to take some of the above considerations into mind.
The author is director, Indian Institute of Foreign Trade. Views are personal