Hiking customs duties was the wrong move
The increase in basic customs duties for some 50 items in the Union budget has been justified on the grounds of the Make In India objective. However, it contradicts the position taken by the prime minister in Davos only a few days earlier, when he spoke about the need to fight protectionism and promote globalization.
Reversing a long-established policy
It is well known that India’s customs duties were very high before the economic reforms, and this produced a high-cost economy unable to compete in world markets. Manmohan Singh began the process of reducing these duties in 1991 and articulated the goal of bringing them in line with those in “other developing countries”. This policy was continued by the United Front government, the Atal Bihari Vajpayee government, and the United Progressive Alliance government.
The sudden reversal of a 26 year trend followed by governments of different political persuasions creates uncertainty about the future. It is also contrary to what the Three-Year Action Agenda published by the NITI Aayog said only six months ago—that customs duties should be unified at 7%. This suggested that we needed to move to lower rates of duty.
Have we now decided that Make In India calls for higher customs duties? If so, there is a real danger of a flood of demands for higher duties wherever domestic industry wants support. Foreign investors will also demand tailor-made protective walls before they invest. Changing duties in an ad hoc manner in specific products will also invite charges of cronyism.
Exchange rate policy vs. customs duties
It is often said that Indian industry deserves duty protection because it suffers from disadvantages such as poor quality infrastructure, high cost of power, difficulty of doing business in India, etc. These are indeed genuine disadvantages, but raising import duties is not the solution. Higher duties help domestic firms to compete against imports, but they raise the cost structure of the economy, and do nothing for exporters who suffer the same disadvantages.
The only way to support domestic producers competing against imports to the same extent as exporters is to move to a more favourable exchange rate. A domestic producer competing against imports gets the same benefit from a 10% depreciation that he gets from an additional 10% customs duty, with the difference that the exchange rate adjustment also benefits exporters.
Has our exchange rate become unfavourable? The Reserve Bank of India’s (RBI’s) real effective exchange rate index suggests it has. This is the weighted average of the indices of the nominal exchange rate against 36 countries, adjusted for the changes in relative price levels between India and each of these countries. This index has appreciated by almost 19% between January 2014 and January 2018. This almost certainly provides an explanation for our poor export performance. It also explains the weakness of domestic competitiveness against imports.
The real effective exchange rate should be one of three key elements in macroeconomic policy, the other two being fiscal policy and the interest rate. Unfortunately, it is somewhat orphaned in the policy structure we have devised for macro policy. We have fiscal rules relating to fiscal deficits, revenue deficits and debt to GDP ratios to guide our fiscal policies. We have a rule for interest rate policy which focuses on inflation targets. There is no such rule for managing/tracking the exchange rate. As a result, those responsible for managing the macroeconomy can be forgiven if they feel that as long as we are doing well on the other rules, it doesn’t matter what happens to the exchange rate!
The formula usually invoked by both RBI and finance ministry to explain our exchange rate policy is as follows. “We do not have a fixed nominal exchange rate target. The exchange rate of the rupee is determined by market forces, but the Reserve Bank stands ready to intervene to curb excessive volatility.” This gives the Reserve Bank the flexibility it needs to intervene in the forex market when it wants to, but without committing it in any way to achieve a particular outcome. In other words, there is no real exchange rate target, towards which the nominal rate will be nudged.
It may not be workable to have a strict real effective exchange rate target, as that would generate speculative pressures, but we do need some broad idea about how the exchange rate should move. It is relevant not just for exports but for all domestic producers that face import competition. The RBI could then nudge the nominal rate in the right direction, either through intervening in the forex market or by moderating the rules regarding capital flows.
If the RBI had a real exchange rate target, such as, for example, stabilizing the index at some level, it would have to manage the nominal exchange rate to counter undesirable movements in the real exchange rate. This means a real exchange rate appreciation would have to be countered by a nominal depreciation. However, this would raise import prices and make it more difficult to achieve the inflation target. The RBI is clearly conflicted.
The finance ministry is also conflicted. At times of fiscal stress, it is tempted to resort to an increase in customs duties. This was clearly the case in the budget because, in addition to the duty increases for specified commodities, the 3% education and health cess on all taxes was replaced, in the case of imports, with a 10% cess on import duties, effectively raising customs duties across the board. All over the world, customs duties are no longer viewed as a source of revenue. Low duties of 3-5% are accepted as the norm, at least for manufactured goods (agriculture everywhere is different).
Endorsing the NITI Aayog proposal of moving to an average of 7% would have been a good move. It would have been seen as a signal that all duties above 7% will be reduced, though the extent and timing of reduction need not be pre-announced as a rigid timetable. It is a mistaken—though widely prevalent—notion that customs duties are borne by foreigners. They are actually borne by Indian consumers and also by exporters, because a rise in customs duties marginally appreciates the exchange rate
Implications for the Act East Policy
The increase in customs duties also potentially undermines the Act East Policy. We face a uniquely unsettled geopolitical situation in the Indo-Pacific region. The US has traditionally enjoyed a leadership role in the region, which it now seems determined to vacate. This gives China an opportunity for unfettered expansion in South-East Asia, both economically and otherwise. China’s GDP (gross domestic product) is five times larger than India’s, measured in market exchange rates, and two-and-a-half times larger in purchasing power parity terms.
Nevertheless, India is the largest economy in developing Asia after China, and we are positioned to grow faster than China if we manage our economic policies well. Our South-East Asian neighbours would welcome the opportunity of greater integration with India, if only to balance to some extent the enormous weight that China has.
Raising customs duties was the wrong card to play at a time when we ought to be positioning ourselves as an open economy, keen to integrate with the rest of Asia. We should remember that it is the openness of our market, not just its absolute size, that makes us an attractive partner for other countries in the region, even though we lag behind China in economic size.
The most important signal we can give at this point, signalling our desire to integrate with this region, is to conclude the Regional Comprehensive Economic Partnership (RCEP) which has long been delayed. The duty increases that have been introduced send the wrong signal, and will only lead Indian businesses to argue against signing.
Our Asean (Association of South East Asian Nations) partners already wonder if we are deliberately delaying the conclusion of RCEP because we want to remain sheltered. This may be unfair. We have made demands for access in services which several of the Asean countries are not willing to accept.
However, all trade negotiations are difficult and ultimately a political call is needed. At that point, we have to consider whether we believe that Indian producers can compete given the right domestic conditions. We should assume they can, and focus all our efforts on ensuring that the necessary domestic conditions are indeed created to allow them to do so.
Implications for Make in India
What does this imply for Make In India? The most important implication is that we must give high priority to tackling the problems of poor infrastructure, poor logistics, high costs of power, difficulties in accessing land, problems in accessing capital, unfriendly tax administrations, delays in contract enforcement, etc. The policy actions needed to bring about these changes are well known. They do involve difficult decisions, some at the state level, but there is really no alternative.
Raising customs duties is certainly not the way to offset other disadvantages and promote Make In India. It will only create a sheltered domestic market to protect inefficient producers. We have seen this movie before. It is very long, and we know it ends badly. Much better to give the NITI Aayog proposal on converging duties to a lower level a fair chance, do a better job of managing the real effective exchange rate, and speed up the process of joining the East Asian region in RCEP.
Montek Singh Ahluwalia was the deputy chairman of the erstwhile Planning Commission.
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