We ‘manufactured’ our trade deficit

India’s burgeoning trade deficit and its impact on the rupee is getting too much media attention these days. A declining rupee leads to increased rupee cost of import and adds to the subsidy burden. Increasing subsidy adversely affects India’s ability to achieve its fiscal targets and poses serious impediments to tackling inflation.

Over the last two decades of liberalisation, the share of merchandise exports in India’s GDP has increased from 6.3 per cent in 1990-91 to 16 per cent in 2010-11. In the same period, import as a proportion of India’s GDP has increased from 8.5 per cent to 23.5 per cent. Consequently, the gap between exports and imports of merchandise has increased from 2.2 per cent to 7.5 per cent of the GDP.

This gap has somewhat been made up by inflows of foreign capital and net export of services. Of late, however, capital inflow has come under pressure primarily because of India’s poor macroeconomic management and slowing economic growth. Exports of services, in particular the IT services and IT-enabled services, , are hit by economic slowdown in the US and the sovereign-debt crisis in the Euro Zone.

Any sensible strategy to address India’s growing trade deficit cannot ignore merchandise exports and among merchandise, export of manufactured goods. Three factors are keeping India’s manufacturing sector from becoming competitive in domestic as well as overseas markets: bad policies, poor supporting infrastructure and autonomous factors.

Bad policies

Economic reforms in India have primarily relied upon opening up the domestic market for imports to infuse competition, expecting that it would improve cost (and quality) competitiveness of indigenous manufacturers and ultimately increase exports. There is nothing wrong with this logic, and it did help initially in increasing India’s exports to $303 billion in 2011-12, from $18.5 billion in 1990-91.

However, in the absence of manufacturing-friendly policies and supporting infrastructure, India’s economic reforms, or the way they have been implemented so far, are increasingly revealing their limitations. While reforms in India have mainly focused on opening up of domestic markets, factors constraining domestic production (in manufacturing as well as agriculture) remain unattended.

For instance, policies such as allowing duty-free import of garments from Bangladesh without the country reducing its import duty on Indian fabrics are hurting India’s textile and clothing sector, the largest employer after agriculture.

Poor regulation, by increasing the cost of doing business, has become the main stumbling block in the growth of indigenous manufacturing. Clearances for land acquisitions and shipping manufactured goods overseas are constrained by cumbersome and expensive regulations. These lie at the root of India’s high-cost manufacturing model. Not only manufacturing, agriculture too is suffering from a series of market-distorting policies — in particular, those related to restriction on sale, inter-state movement, export and price control of farm produce.

Poor performance of agriculture puts limits on growth of the manufacturing sector as it is a key source of raw material. Increased farm income generates demand for industrial goods and acts as a bulwark when other sectors of the economy are in trouble.

Lower agricultural production leads to food inflation, which in turn leads to demand for hike in the industrial wages. This increases the cost of production in the manufacturing sector.

Supporting infrastructure

The condition of roads, ports and power supply in India is less than desirable. The supply and costs of these essential factors of production is a problem when compared with what prevails in other economies. Measured by the ratio of the price of one million kWh to per capita GDP, the cost of electricity in India is roughly 20 times as high as that in the US. Imposition of green energy norms in an increasingly climate-conscious world will further affect the cost competitiveness of India’s manufacturing sector.

This production-unfriendly environment is driving Indian capital out of the national boundaries. This outflow of capital will not be good for India’s balance of payments when current account deficit is already crossing 4 per cent of GDP and foreign investors are nervous about the India story.

Autonomous factors

The manufacturing sector is being hit by the following: Increased proportion of import content in India’s manufacturing processes on account of emphasis on capital-intensive production technologies (in the absence of labour reforms); change in consumer preferences, which often requires use of imported inputs; and the depreciating rupee. The growing import/GDP ratio on account of increased import eats into the demand for India’s manufacturing sector, already suffering from global slowdown and high capital cost.

India’s high-cost manufacturing model can also be explained by relatively faster growth in salaries and wages than (labour) productivity as compared with that in countries such as China. For instance, in some of key manufacturing sectors such as textiles, wages have grown by 10 times in the last two decades.

What can be done?

What the manufacturing sector needs is a level playing field that is lacking when one considers the prohibitive cost of capital, business-unfriendly regulations and influx of cheap imports on account of trade liberalisation.

To make its manufacturing sector internationally competitive, India needs a multi-pronged approach. Transforming India’s regulatory regime into an industry-friendly regime will require, among others, over-hauling of regulations related to documentation, land acquisition, environmental clearance and taxation.

Removal of restrictions on inter-State movement of goods and services to ensure their seamless movement will provide resilience to the economy up against the global economic slowdown. Further reduction or removal of import duties on key industrial raw materials will reduce working capital requirement in a high-interest regime.

When it comes to fully realising India’s manufacturing export potential, improvement in transport and logistics infrastructure can bring the maximum gain in improving our export competitiveness.

Furthering intra-Asian economic integration will help India’s manufacturing sector in two ways: by opening up newer markets for improving scale economies and sourcing of inputs at competitive prices.

(The author is General Manager and Group Economist, Raymond Ltd. The views are personal.)

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