C P Chandrasekhar & Jayati Ghosh

The looming external trade crisis

C.P.CHANDRASEKHAR JAYATI GHOSH | Updated on October 15, 2012

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Developments on export and balance of payments fronts suggest that India is on the verge of a sharp downturn in output and employment unless the policy response is strong, argue C.P. Chandrasekhar and Jayati Ghosh in this edition of MacroScan.

As if domestic economic and political developments were not enough to worry about, we are now confronted with concrete evidence of adverse changes on the external trade front. The most recent data on foreign trade released by the Directorate General of Commercial Intelligence and Statistics reveal that the deceleration in exports that has been evident in the past few months has continued into September, but because imports also rose in that month despite slowing GDP growth, the trade deficit is even larger than before.

Concerns about the fragility of the Indian balance of payments and about the growing imbalances in trade have been expressed in this column for some time. But now the issue has become so pressing that it is surprising that it is not treated with more urgency by policymakers in the Government. Instead, in terms of external economic policy, the focus seems to be only on attracting more foreign investment, including in non-tradable activities such as retail trade, which would in all likelihood operate to further worsen the trade imbalance.

Rapid dip

Chart 1 describes the behaviour of exports, imports and the trade balance since the early part of the previous decade. While the overall trade balance has been in deficit throughput this period, the amount of this deficit was really quite low in 2003-04 (and indeed the non-oil trade balance was in surplus at that time). The deterioration in the trade balance was especially rapid from 2008-09.

It is often argued that this is because of high global oil prices, which necessarily operate to increase India’s import bill and therefore cause the trade account to worsen. But Chart 1 shows that non-oil imports also increased rapidly and at a similar rate, as the Indian economy’s overall growth trajectory became increasingly import-intensive.

The story of oil trade is also of particular interest in recent times. As is evident from Chart 2, oil exports have become increasingly significant, even at a time when the oil trade balance has been more heavily in deficit. In the early 1980s, the export of petroleum products reflected the lack of domestic processing capacity, as crude oil and natural gas from India was exported and refined oil products were imported. But that is no longer the case.

Instead, these oil exports are largely driven by the behaviour of one private company, Reliance Industries, which has been exploiting domestic and international price differences for particular petroleum products and benefiting from various concessions provided for exporters, in order to maximise profits. In a context in which refined oil for energy use is such a significant and increasingly scarce commodity within India, the purpose of increasing domestic refining capacity was really to ensure that India’s growing demand for refined oil can be met domestically at affordable prices. So it can be questioned whether allowing such a strategy on the part of private players is in the national interest.

High imports

The more recent behaviour of merchandise trade indicators is indicated in Chart 3. It is already evident that the current financial year is showing even worse trade performance than 2011-12. Exports have continued to fall in dollar terms in the first quarter of this year. However, the decline in imports is more marginal and indeed in the most recent quarter there was even a slight increase. This is despite the overall deceleration of GDP growth, and points to the growing import dependence of domestic activity, a feature that has been widely noted in many open economies before they have experienced financial and balance of payments crises.

The deceleration is even more sharply evident in Chart 4, which provides year-on-year growth rates of exports and imports by month for the period since April 2011. Export growth in US dollar terms remained high for most of 2011, despite the slowdown in the global economy that was already evident.

But it slumped sharply in November 2011, and has never quite recovered. Since March this year, exports have generally been in negative territory compared to the same month of the previous year, and the rate of decline has got progressively worse. Imports on the other hand stayed quite high for some time longer, growing at year-on-year rates higher than 20 per cent until March, and only started declining thereafter. Import growth was also negative from April to August, but in September it appears to have recovered to be more than 5 per cent higher in dollar terms than in September 2011.

How much of the deterioration of exports can be ascribed to poor global economic conditions? In particular, has the recent slowdown in major markets in the North affected Indian export growth? Chart 5 tracks Indian exports to some important destinations, which together account for just under half of the country’s total exports (and in fact the proportion has increased in the latter part of this period).

Exports stagnant

What is noteworthy is that it is only the Chinese market that appears to have been significantly reduced in the more recent months. Exports to the four big European economies (France, Germany, Italy and the UK) are definitely lower than they were at their peak in March 2011, but after declining in April 2011, they have mostly fluctuated mildly around a stagnant trend rather than showing a clear declining trend.

Exports to the US also have not been as buoyant as earlier but have not really declined in any sustained fashion either. Meanwhile, exports to the oil-exporting countries of Kuwait, Saudi Arabia and the United Arab Emirates have been volatile around an increasing trend, reflecting the continued high purchasing power of these countries because of the high world oil prices.

What adds to the conundrum is the fact that these trends in India’s exports and trade balance are coterminous with some really sharp changes in exchange rates. In the past year and a half, the rupee has depreciated in nominal terms by around 20 per cent — a fairly sharp reduction for supposedly normal (that is, non-crisis) times. But what may be even more surprising is that the real effective exchange rate (REER) appears to have fallen to an almost similar extent.

Chart 6 indicates that both REERs fell rapidly after July 2011, by around 13 per cent for the trade-weighted REER and more than 18 per cent for the export-based REER. Such sharp falls are surprising because aggregate inflation in India has been significantly higher than that in most of India’s trading partners.

Obviously, prices of export goods have not risen commensurately, which is what has enabled the real effective devaluation. This suggests that the export sector has been forced to suppress its own prices so as to cope with international competition in increasingly difficult external circumstances.

With such a large and rapid decline in the real exchange rate, the continued deterioration of the trade account is somewhat surprising.

Of course, it is well known that trade balances respond with a lag, in what is known as the J-curve effect. However, many of the commodities that India exports are manufactured goods for which the response is likely to have been felt within three or four months, and this has clearly not happened yet.

However, given the extent of the real exchange rate depreciation, it may well be that Indian policymakers are simply waiting for the impact of this particular macro-price to work its way through the system and generate an improvement in the trade balance. This may explain at least some of the policy inaction on the trade front thus far.

Risky strategy

However, this is a risky strategy, for several reasons. First, it assumes that the worst is over in terms of trends in global markets. However, it should be evident now that the world is clearly on the brink of another major recession and export markets will deteriorate further before there is any real chance of improvement. Second, it does not recognise that the real impacts of a trade deficit extend beyond the balance of payments to the effects on domestic economic activity — and that trade deficits have strongly negative repercussions on output and employment.

With the government declaring that it is committed to reducing its fiscal deficit through a reduction in expenditures in order to combat inflation and appease foreign investors, the contraction in economic activity could be substantial. The delayed effects of the global crisis on India can prove to be far more intense than the immediate impact it has had. These are concerns that cannot be ignored — so more urgent policy action to redirect economic activity towards the home market while reducing the trade deficit is clearly required.

Burgeoning imports need to be controlled — not by contracting economic activity, but by developing methods to ensure the expansion of the domestic market for domestic producers, particularly small and medium industries.

Published on October 15, 2012

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