Graphic: Mint
Graphic: Mint

Increasing tariffs may not be an effective solution to curb the rupee’s weakness

Some other options that the government may have to choose from to deal with the rupee's depreciation are increasing interest rates or opting for foreign bonds/NRI bonds to shore up the country's forex reserves

The government plans to increase import duties on a few non-essential items such as gold, electronics and steel, to provide some support to the depreciating rupee. Rising imports coupled with a weakening rupee would push the country’s trade deficit higher and consequently worsen the current account deficit. The question now is whether import duty hikes would prove helpful in containing the rupee’s rout.

Let’s first consider gold, for which demand in India is typically strong. According to Bank of America Merrill Lynch Global Research, gold demand is not likely to react to 5-10% tariff hikes, especially given higher minimum support price increases and a step-up in loan waivers.

In 2013, when the government raised import duty on gold, imports of the yellow metal did fall but unofficial gold imports rose, pointed out Madan Sabnavis, chief economist at CARE Ratings Ltd. Note that import duty on gold is already high at 10%, so the risk that there will be sharp increases is lower. Additionally, consumers of the yellow metal are already paying a 3% goods and services tax on the commodity.

For electronic items, demand may not be that price-sensitive. Electronic items have weighed heavily on India’s trade deficit lately and the impact they have on the overall trade deficit has risen over time. This suggests that demand for electronics is strong and may not be negatively affected by higher import duty.

For steel, “In order to reduce dependency on imports of certain varieties and to encourage domestic production of these varieties, we believe that the customs duty on some of the steel products could be increased to 15%," pointed out a report from CARE Ratings.

“At the same time, the government would have to ensure that this indicative duty hike does not materially impact the exports from those industries which use these imported steel products as an input for manufacturing of its goods," it added.

According to Bank of America Merrill Lynch, steel tariff hikes may not scale down imports from Japan and South Korea (33% of imports) with which India has free trade agreements, although they reduce the risk of dumping from China.

Further, if duties are raised, the threat of imported inflation would increase, said Sabnavis. Data sourced from the research wing of State Bank of India shows that imported inflation surged to a multi-year high of 9.27% in August.

Some other options that the government may have to choose from to deal with the rupee’s depreciation are increasing interest rates or opting for foreign bonds/NRI bonds to shore up the country’s forex reserves.

While some economists are not ruling out a rate hike by the Reserve Bank of India, they feel aggressive rate hikes are not an ideal solution for India and would hurt domestic growth. Also, it could result in outflows by foreign investors invested in Indian equities.

Not surprisingly, some economists are rooting for NRI bonds. The most recent was the FCNR (Foreign Currency Non-Resident) deposit scheme that was introduced in September 2013. However, 2013 is not 2018. Overnight Libor (London Interbank Offered Rate) was much lower at about 0.1% in September 2013, whereas the measure is at 1.92% currently. This means that interest rates have to be far more attractive for NRI bonds to succeed this time around.

That said, increasing import duties would at best be a short-term solution. Nonetheless, if duties are increased, the money should be used to incentivize and diversify the local manufacturing base. In short, we should work towards reducing our reliance on imports.

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