Indian policymakers have for long been worried about the sheer scale of our trade deficit with China. The commerce ministry said this week that the trade deficit with China came down by $10 billion in the fiscal year ended March 2019 to $53 billion. The commerce minister took to Twitter to announce this. However, Asit Ranjan Mishra reported in this newspaper on Monday that China has begun to ship some of its products through Hong Kong rather than its domestic ports. The combined Indian trade deficit with China plus Hong Kong has not budged.

India’s bilateral trade deficit with China plus Hong Kong is about a third of its total trade deficit with all countries put together. That with China alone is around a quarter of the total trade deficit. The latter too has shrunk in the previous fiscal year because of an uptick in exports. Investment bank Credit Suisse AG says in a recent report that the shrinking trade deficit reinforces the view that global momentum remains strong while domestic demand is weakening. The former is helping export growth while the latter is restricting imports.

Should India be worried about its bilateral trade deficit with China? The International Monetary Fund (IMF) has taken a closer look at the problem of bilateral trade imbalances in its latest World Economic Outlook, based on a study of 63 countries over 20 years.

There are two broad arguments made by the multilateral lender that are relevant to the ongoing problem of India's trade deficit with China. First, bilateral trade imbalances are largely driven by macroeconomic factors rather than tariffs. Second, changes in a country’s overall trade balance tends to affect its trade balances with individual countries, but the opposite is not true since any attempt to change a bilateral trade imbalance through tariffs will only lead to diversion of that trade to other countries.

The role of macroeconomic factors cannot be denied. For example, a country that follows an expansionary fiscal policy when it is already close to potential growth leads to a higher demand for imports. The international division of labour also matters. A country which specializes in manufacturing while its trade partner consumes more industrial products than it does will naturally see trade flows. The China trade problem is a slightly more complicated one for three reasons.

First, while basic macroeconomic accounting tells us that China runs a huge trade surplus because it saves more than it invests, it has also been strongly interventionist in the way it has managed its exchange rate. Its sustained currency manipulation is reflected in its $3 trillion foreign exchange reserves hoard.

Second, China has actively used subsidies to promote its domestic industry, giving it an unfair advantage in many areas. The IMF has also noted it in its new report: “Output was also growing faster than spending in China over this period—in part reflecting domestic supply-side policies, such as subsidies to the cost of production of manufactured…goods."

Third, there are fears in parts of the Indian policy establishment about deep links between the Chinese industrial sector and the government in Beijing, so the bilateral trade deficit has become part of a larger geostrategic dilemma. This is especially true of specific items such as consumer electronics, telecom equipment and power equipment.

There is no doubt that India's trade deficit with China is part of a larger challenge of trade competitiveness, which encompasses a range of issues from domestic macroeconomic imbalances to the failure to plug into global supply chains. However, there are also good reasons to focus on the trade deficit with China as a specific policy challenge. However, bilateral tariff wars are not the solution because Indian consumers will merely buy from other countries, or China can channel its exports into India Inthrough third countries such as Hong Kong.

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The question is whether India can rein in its domestic macroeconomic imbalances on one hand and build competitive industrial capabilities on the other. A previous instalment of this column had argued that the US-China trade war provides India with a juicy opportunity to get back into the global manufacturing base, as the global supply chain gets rewired. Rising wages in China are also another factor that could work for India. The unfortunate fact is that India is losing out to regional peers such as Vietnam, Indonesia, Bangladesh, Malaysia and the Philippines.

Large global investment projects will be the key. Bloomberg has reported that Foxconn Technology Co. Ltd will begin mass-producing Apple iPhones this year at its factory outside Chennai. The Taiwanese company also makes phones for Xiaomi and Nokia in India. This could perhaps be the beginning, but it is clearly too early to jump to any grandiose conclusions. The larger lesson is that such industrial projects should help India plug into global supply chains, and use them as conveyer belts for exports of manufactured goods.

Niranjan Rajadhyaksha is research director and senior fellow at IDFC Institute. Read Niranjan’s previous Mint columns at www.livemint.com/cafeeconomics

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