India’s trade policy: Import substitution or tariff intervention?

Prof Manoj Pant, Director, Indian Institute of Foreign Trade argues that from a long-term point of view, import substitution should be seen along with the Production Linked Incentive (PLI) Scheme, and quality control must be also linked to the scheme. Over time, the aim should be that the items under PLI cease to be protected. 

• Import substitution of the 1950s and 1960s is no longer valid owing to the reasons such as a change in nature of trade, the existence of supply chains, and the existence of WTO. 
• In Budget 2020-21, a tariff has been raised on 1243 items out of 10,400 items. These items accounted for roughly about 16% of imports.
• The objectives for tariff increase are to create a level playing field for domestic industry and to increase domestic value-added.
• From a long-term point of view, the import substitution should be seen along with PLI Scheme. For PLI to work, it must also be fairly open as far as foreign companies are concerned.

The concept of import substitution goes back ages to the 1780s when the “infant industry argument” was first talked about. The argument was that domestic industry cannot very easily compete with external industry, as they are new in the business. The external players, whereas, have a lot of experience, and access to funds at favorable good rates. Thus, the domestic industry needs protection to compete, before they can compete with the outside world. During the period of protection, domestic companies are supposed to grow through learning by doing. The newborn companies will work in a protected market and will learn to become competitive before they can face the rest of the world. 

In 1950s and 1960s, Japan and South Korea practiced import substitution. They raised their tariff barriers to build up domestic capacity very successfully. During the time, the domestic companies became able to compete with the rest of the world in the outside model.  Today, however, the meaning of import substitution is very different. The first reason for this is that WTO does not allow the kind of import substitution that could be practiced in the 1950s. The second is the nature of trade which has changed completely since the 1950s and 1960s. In the last century and maybe in the 19th century as well, we had three classes of trade which are primary goods, manufactured or secondary goods, and tertiary goods like services.

So, it was easy to talk about final goods and intermediate goods. Trade statistics to a certain extent were written in that way. You could look at the level of processing of a product from an intermediate to final good, in terms of the classification of trade. However, it is no longer true now due to two reasons. In academic terms, the reason is called the ‘existence of intra industry trade’ and the more popular term for it is “supply chains”. No country today makes a product on its own. The last such case was Malaysia deciding to make a car called the Proton on its own and it was a disaster. Within one or two years they folded up and now that car is made in collaboration with Volkswagen in Germany. 

With the tremendous decline in communication costs and tariffs around the world towards the end of the last century, today it is much better to transport parts and components from wherever they are cheapest and assemble them at the point where they are best easy to sell. This process is called the supply chain. Today, it’s impossible to export anything if you’re not part of a supply chain. Thus, supply chains make the whole concept of import substitution of the 1950s, and 1960s are redundant. 

Now, if you look at the data, it shows that the import intensity of exports has been increasing. Everyone buys something from someone else, puts some value to it and exports the result. Thus, the nature of trade has changed, the existence of supply chains, the existence of WTO, which means the meaning of import substitution which was relevant in 1950s and 1960s is no longer valid. 

What has actually happened recently?

According to the data from Budget 2021-22, there has been at least some increase in tariffs in 1,243 items out of 10,400 items. These items accounted for roughly about 16% of imports (US $76 billion) in 2019-20. The heads under which tariffs on these items were increased are important to notice. 

The first head under which this was done was to create a level playing field for the domestic industry. It is a little like the infant industry argument. However, the difference is that as countries have changed over time, everyone has their own local issues. Some of our exporters need some adjustments for duties, which used to be duty drawback earlier and became irrelevant with the GST.

Basically, you try to set off domestic taxes so the competitive advantage gets reflected really in the numbers. For creating a level playing field measures have been taken by the government such as Merchandise Export Incentive Scheme (MEIS), which was declared WTO inconsistent, and now Remission of Duties and Taxes on Export Products (RoDTEP) and other measures I’m sure the government will take. The kind of items included are some agricultural items, auto parts, and various kinds of leather. 

The second head is domestic value-added needed to be increased. As per basic logic, when you are in a supply chain and you are exporting a product where the domestic value-added is zero or very small, then you probably should not be exporting. You should be adding value to something if you import something and then add some personal value, and then export. Otherwise, there is no point in being too interested in those items. And here were the major items which account for roughly about 68% of the total impositions values. And these items are mainly electronic items, mobile parts, printed circuit boards, compressors for the refrigerators, A/C, etc. 

Webinar on ‘Has import substitution worked for India – Challenges & Road Ahead’ by Trade Promotion Council of India

The other bit of statistic worth looking for is that these items accounted for roughly about 40% of imports from China, according to data from the global trade alert database. Not only China, but the imports also come from countries like Singapore, South Asia and so on. Now, this is called import substitution. 

First of all, this is not the classic import substitution. It is not like all electronic goods are being stopped. The other aspect is also being kept in mind, because some exporters have received exemptions on the ground that those import items are critical for their export effort. So the import intensity of these exports was high and they are important exporters. And I think that’s one exercise the government should do. 

However, I never viewed this as the kind of import substitution or input protection as the media calls it. It might be for one person but it is not a general import substitution. We have been seeing a contraction in world trade since about 2008 as it is stuck at about 60% GDP. Every country is doing a little bit. Some people are using non-tariff barriers while some others doing political demonstrations. 

How to make import substitution work?

From a long-term point of view, import substitution should be seen along with the incentive called Production Linked Incentive (PLI) Scheme. PLI scheme is different from the earlier Capital Goods Export Guarantee Scheme in the sense you don’t get anything upfront. If the expansion of production is more than a certain fraction, then a certain fraction of incremental sales is given to you as an incentive. 

It is a performance-related incentive scheme. The government also insisted that we have to follow international norms. So quality control issues have also been linked to PLI. And I think the objective is the linking of PLI with quality and also, future performance over time. These items which the government keeps expanding under PLI are basically the kind of items we are talking about. Over time, these items must cease to be protected. 

So you must see the import substitution over time, can also be called “import duty protection” of the 2021-22 budget, in the context of similar, what I may call a sister scheme to PLI. The PLI, I think, is what may make the scheme sustainable, otherwise, you will not be able to continue doing it. However, you have to see the PLI along with the relaxation of issues on FDI.

FDI and trade are not two different things. In today’s world where everything is an input into everything, 60-70% of world trade is conducted between units of the same multinational company. The reality of the global ecosystem today is intra-firm trade. These companies are not here because either they want to buy reasonably cheap inputs or they want to sell something.

At least they want to trade, they either want to import from you, or they want to export for you. So if PLI is conducted very seriously, along with FDI policies, it will do what often happens, i.e., FDI comes into the country, mainly because it’s able to set up a domestic capacity. If the domestic capacity could be channeled into areas which in any case are important for the economy from domestic production or export, an increase in exports should also take place as a byproduct.

And, for this, most important is the defence industry, which was opened up very recently. So for PLI to work, it must also be fairly open as far as foreigners are concerned. And I’m talking about Foreign Direct Investment here, which is traditionally defined as companies investing in subsidiaries within countries. FDI always accompanies a long-term transfer of knowledge of technology. I can give you 100 studies in 100 countries to show that it happens as a byproduct of learning by doing, which comes from one, the domestic market and two, competition from foreign firms. That’s an essential part of IT. 

The second thing is the problem of negotiating the FTAs. We should be looking in the right direction; it’s very useful that now they are looking in the right directions, which is Europe and UK – that’s where the big markets are. Next are Latin America, Middle East, and Africa. When you negotiate Regional Trade Agreements (RTAs), the tariff reduction comes with reference to the MFN rate at the time when you make the RTA. So ASEAN FTA was done with reference to 2007 MFN rates.

Now I’m given to understand that the recent duty increases except for those items which were covered in National Technology Agreement, are well within our bound duty commitments. But I think that in some of the items like auto parts, where duties have gone up, you’re going to have a problem in RTAs. You have got to be careful when you do this temporary import duty raises because they are going to come up for discussion in the new RTAs to be finalized. And these European, UK RTAs do have an economic impact, unlike the ASEAN one. If they agree to apply, that is fine, because most of the tariffs I know in most of the items are below your bound rates in the WTO. 

So let me summarize by saying I don’t think India is doing import substitution like the media seems to be saying. I believe that this is limited to what I call tariff intervention because we don’t know what to do about China, which is a black box as far as economic policies are concerned. And because we are not doing China-specific duties, therefore we bring in these restrictions basically on the set of items.

But this will not sustain. In the next year, we’ll have to figure out what is the long-term policy. At last, please always remember, every export is an import and every import is an export. Why would you export when you didn’t want to import? And why would you import if you couldn’t pay for exports? Finally, I would also like to re-emphasise that the link between FDI and trade is very crucial to bring into administration. 

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This column is based on the insightful opinions of Prof Manoj Pant presented during the webinar “Has import substitution worked for India- Challenges & Road Ahead” organised by Trade Promotion Council of India.