The dangers of India’s rising tariff walls

Trouble is, wanting to increase exports and being increasingly protectionist at the same time work at cross purposes. And that’s the bad news.

In fact, raising customs duties goes against what has been done since 1991, with duties being cut all along. This boosted exports (and growth) all along.

The weighted average tariff rate in 1990 stood at 56.4%. In FY91, total exports to gross domestic product (GDP, a measure of the size of the economy) ratio was 6.24%. Over the years, as customs duties were cut, exports boomed. By 2013, the weighted average tariff rate had fallen to 6.34%. Exports peaked in FY14 at 25.18% of GDP. India’s exports to GDP ratio has been coming down over the years. In FY20, it is expected to be at 19.5% of GDP (in constant terms, adjusted for inflation).

Over the past few years, the government and policymakers seem to be forgetting this basic fact. In this piece, we shall explore this policy disconnect through the example of the humble mobile phone, and how it has become more expensive, albeit marginally, over the years.

Higher protectionism

The history of economic development suggests most countries that have gone from being developing to becoming developed nations, have done so on the basis of a manufacturing-led exports revolution. In the past few decades, this has happened with manufacturing units in developing countries becoming a part of global value chains involved in the making of a product.

Policymakers and the government are coming to this realization now. Finance minister Nirmala Sitharaman summarized the situation perfectly in her recent budget speech: “India needs to manufacture networked products. That will make it a part of global value chains."

The idea is to start at the lowest part of the value chain—assembling of products. This is labour-intensive. And, then, as the Economic Survey puts it, “Domestic firms graduate up the production value chain by first starting with low-technology operations such as assembly and then moving to manufacturing of components." Hence, the idea is to encourage these kind of exports.

The trouble is that along with export ambitions, India is becoming increasingly protectionist. In fact, no one said this more clearly than former finance minister the late Arun Jaitley, in a budget speech he made in February 2018: “In this budget, I am making a calibrated departure from the underlying policy in the last two decades, wherein the trend largely was to reduce the customs duty."

Sitharaman is taking forward this legacy. In the budget for FY21, she raised customs duties on 37 items in order to provide a level playing field for the domestic industry. Sitharaman raised customs duties on 10 more items in order to generate additional revenues. Her budget also proposed to change the Customs Act of 1962, to give the government the power to ban import or export of any goods (earlier this only applied to gold and silver).

India’s tilt towards increased protectionism can also be seen in the government’s decision to not become a part of the free trade agreement, Regional Comprehensive Economic Partnership.

The data lag

The weighted average tariff rate of India in 2018 had stood at 4.88%, down from 7.32% in 2015. That said, increased protectionism will eventually show up in data as well.

At one level, the trend of higher customs duties on imports harks back to import substitution that prevailed before 1991. Then, companies were encouraged to produce only for the domestic market. But there is an inherent disconnect here with the policy meant to be encouraging exports.

Like India, the countries of South-East Asia also started with import substitution, but quickly shifted their focus towards exports. India continued to favour import substitution for much longer, and this has had its repercussions. When companies produce for the global market, they need to compete with the best in the world. This automatically leads to a situation where the products that a company produces need to be globally competitive.

Given the aim is to become a part of global value chains, Indian companies will need to be globally competitive. The question is how will they become competitive by just producing for the domestic market and not face external competition (which higher customs duties make unviable).

Beep, beep

One of the success stories of Make in India has been manufacturing of the mobile phone or handset. It is estimated that the production of mobile phones has gone up from 60 million units (valued at ₹18,900 crore) in FY15 to 290 million units (valued ₹1.7 trillion) in FY19.

As per industry body India Cellular and Electronics Association, there are 268 units in the country manufacturing handsets and components. These units have a total manufacturing capacity of 350 million units per annum and they employ 670,000 people. One clear impact of this has been a marked decrease in mobile phone imports. In FY17, these had stood at 75.78 million units, and dropped to 26.98 million units by FY19. These numbers point towards the success of a home-grown mobile phone industry.

This success has come on the back of increasing customs duty on imports of mobile phones. As Rekha Mishra and Anand Shankar of Reserve Bank of India’s (RBI’s) international trade division write in an article titled India Connected: Transforming India’s Import Profile: “Increases in the basic customs duty on imports of mobile phones from nil to 10% in July 2017 and further to 15% in December 2017 and to 20% in February 2018 have discouraged imports further while supporting domestic production."

Also, the government introduced the phased manufacturing programme for handsets and related sub-assemblies/components manufacturing, through the budget of FY16. Between FY17 and FY19, the government increased the basic customs duty on 11 parts that go into the making of a mobile phone, to encourage firms to manufacture these parts in India.

The idea behind increasing the customs duty on these products is to encourage the making of cellphone parts in the country. The higher the proportion of a mobile phone that is made in India, the more the country will benefit.

But that doesn’t seem to be happening. This is something that the latest Economic Survey points out as well: “Between 2013 and 2017, while India’s import of telecom handsets declined from $4.47 billion to $3.31 billion that of telecom parts increased steadily from $1.34 billion to $9.41 billion."

In fact, this is a trend that seems to have continued post 2017 as well. In FY19, mobile phone parts worth $16.28 billion were imported. This tells us India is importing fewer mobile phones over the years, but the same is not true about cellphone parts.

As Mishra and Shankar of RBI write: “Mobile phone imports are negatively correlated with the…imports of mobile phone parts, implying that decline in mobile phone imports has been accompanied by an increase in imports of mobile phone parts." The larger point being that much value is not being added within the country. If that was the case, the import of mobile phone parts would also have been coming down.

The disconnect

In the budget speech earlier this month, Sitharaman proposed to increase/initiate import duties on a few mobile phone parts, in FY21. A customs duty of 10% has been introduced on the vibrator motor. Now let’s say a manufacturing unit decides to make the vibrator motor in India. It will be at least 10% costlier than the vibrator motor available from overseas (given that there is an import duty).

Taking this into account, anyone who plans to make mobile phones for the exports market will be starting with a cost disadvantage. Other than the vibrator motor, a customs duty of 10% has been introduced on the display panel of cellphones as well. Over and above this, the customs duty on printed circuit board assembly has been increased from 10% to 20%. All this will add to the cost disadvantage when it comes to exports. Hence, increased protectionism encourages domestic manufacturing, not exports. It is worth remembering that the world is a bigger market than India.

This cost disadvantage will go up over a period of time if a customs duty is introduced on more parts. In fact, as far as the cellphone exports are concerned, India had exported around 18 million handsets in FY19, earning $1.4 billion in the process. The interesting thing is that the country had exported mobile phones worth $2.7 billion, back in FY13.

The fact that India’s imports of cellphone parts have been growing also tells us that even exporters have been importing components that go into the making of a mobile phone.

The consumer angle

In economics, there are seen effects and there are unseen effects. The seen effect of protectionism is very straightforward. It makes imports expensive and domestically manufactured products viable. This helps domestic manufacturers and allows them to stay in business.

But there is an unseen effect to all this as well. Over the years, we have often heard the rhetoric around asking consumers to boycott Chinese products. The trouble is no one is forcing anyone to buy Chinese products. They are doing it out of their own free volition because they are more value for money. If customs duty is increased on these products, people will be forced to buy more expensive domestically produced products.

Well, the domestic inflation in handsets has increased over the years (see chart). It is not a huge rise, but it is an increase nonetheless. Also, it is worth remembering that prices of electronic products typically tend to fall as time goes along, and not rise. In fact, as India has become increasingly protectionist, cellphone prices have gone up.

The interesting thing is that in FY20, between April and December, handset prices have risen by just 0.5%. This is primarily because no new customs duties were introduced on mobile phone parts in the budget presented in July 2019. Also, duties on the camera module of cellphones and charger/adapter were slashed to zero. Hence, protectionism is anti-consumer.

When an individual spends more on something, she cuts down on expenditure in some other area. Given this, if one business benefits due to protectionism, another business or other businesses, lose out in the process. It’s just that this is not so obvious in the first place and hence, is the unseen effect of protectionism.

In conclusion

In the long-term, protectionism as a policy is going to hurt the Indian economy. At the same time, Indian businesses are really not in a position to compete with outsiders. So, what is the way out? As the Economic Survey points out: “Manufacturing units have to conform with 6,796 compliance items, which is a tedious and time consuming task. It must be noted that this is not a comprehensive list and not every rule applies to every manufacturer. It is just an illustration of the bewilderingly wide range of rules that the sector faces."

For starters, these compliance items need to be whittled down, one by one.

Vivek Kaul is an economist and the author of the Easy Money trilogy.