The trade part of India’s external balance story post-reform | Number Theory

China, even though it is now past its growth peak, invests much more than India even in relative (share of GDP) terms.

A falling rupee, outbound portfolio investment and sluggish foreign direct investment are flashing amber on India’s external accounts dashboard. If the ongoing oil shock persists and the trade deficit widens further, the pressure will intensify. While recent debate has focused on FDI, portfolio flows and exchange rate, a long-term look at India’s trade deficit is equally important to understand the problem.

A cargo ship sailing into a port amid the West Asia conflict. (AFP)

The trade part of India’s external balance story post-reform

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  India’s trade deficit has increased significantly from what it was in 1991

  Any discussion of external balance risks inevitably evokes memories of the 1991 crisis, when India stood at the precipice of a sovereign default. What most people do not realise is that India’s trade deficit was much smaller relative to the size of its economy back then: less than 2% of GDP in the five years ending 1991-92 and never more than 4% until 1966-67, the earliest period for which CMIE has data. The deficit worsened consistently after economic reforms, breached the 4% barrier in 2005-06 and has never fallen below that level, barring the pandemic year. The rise in the trade deficit post-reforms—also a result of removing policy restrictions on imports and foreign exchange—means India now needs a much larger surplus in current account invisibles and capital account to balance its external ledger. It is also important to underline that the rise in the trade deficit has largely been driven by non-oil imports rather than India’s endowment deficit in fossil fuels.
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  What really explains the rise in non-oil trade deficit

  The best way to answer this question is to compare India’s merchandise trade with China, the world’s biggest exporter by a distance. This comparison is useful because knee-jerk reactions to a higher trade deficit often lean toward stopping imports. India’s imports, as a share of China’s have actually shrunk marginally between 1992 and 2023, the earliest and latest period for which use-based classification of trade for the two countries is available in the World Bank’s WITS database. The distance between Chinese and Indian exports, however, has doubled in these three decades. Simply put, China runs a trade surplus and India a trade deficit not because China imports less than India but because it exports far more. In 2023, India exported less in capital goods, intermediate goods and consumer goods, but relatively more in raw materials compared to China than it did in 1992. This suggests the Chinese economy is moving toward more value-added exports than India. On the import side, the biggest increase in the China-India gap has come in raw material and consumer goods imports while India’s relative disadvantage has reduced in capital and intermediate goods. This once again, highlights China’s growing lead in value added exports and a rise in the size of its domestic market.
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  Why has India missed the value-added export bus?

  It takes factories to make things for export, and investments to build factories. China, even though it is now past its growth peak, invests much more than India even in relative (share of GDP) terms. The absolute difference is huge given the GDP differential between China and India. India’s investment-to-GDP ratio peaked in the 2000s. Things went downhill during the 2010s; partly a result of the bad loan overhang the earlier boom left and partly the end of the pre–Global Financial Crisis export boom. Despite many policy interventions ranging from tax cuts for businesses to now households and a rising debt appetite among households, investment refuses to resurrect. Unless this happens, and India can get its trade deficit under control by increasing exports rather than cutting imports, the external balance will be at the mercy of global sentiment on India (read capital flows). It is not a very palatable fact for an economy that sees itself as soon to be the third largest in the world, but it is a fact nevertheless.