International linkages: India’s comparative advantage and trade patterns

All of us have heard a multitude of things about the world becoming a global village today where the boundaries of nations are getting blurred with each passing day. International trade between India and other countries is widespread and at its peak since the economic reforms of 1991 liberalized India’s economy including foreign investment, tax reforms, banking reforms, and liberalization of international trade. Before 1991, India’s trade with other economies was very limited and regulated due to the government’s inward-looking policies. In 991 however, owing to the reforms that were given a green light under Prime Minister Narasimha Rao’s government- India started engaging in extensive trade with the rest of the world. These measures helped the Indian economy gain traction.  Since then, India’s economy has advanced substantially and given way to a more globalized world.

Our understanding of events refines with time. Even though the reforms were originally implemented to help the country get through the 1991 Balance of Payments crisis, the alterations they brought about went beyond the requirements set by the International Monetary Fund for the bailout.

What are the implications of these reforms in the world that we live in today? How has India’s trade policy panned out since then? How does a nation decide if it is more beneficial to produce a good domestically or import it from outside? How are these important trade policy decisions made?

International economics as a discipline tries to provide answers to all the above questions by studying the international variations in productive resources and consumer preferences across national boundaries that affect economic activity. It aims to explain the trends and effects of exchanges and transactions, including commerce and investment, between inhabitants of various nations.

Comparative Advantage is the concept through which nations decide which products & services to export and which ones to import. To be able to understand comparative advantage, it is necessary to understand what absolute advantage is. The ability to generate more or better goods and services than competitors is referred to as having an absolute advantage. The ability to create goods and services at a lower opportunity cost, not necessarily at a higher volume or quality, is referred to as having a comparative advantage.

As per the Indian Council for Research on International Economic Relations’ research paper, India has a competitive advantage in 1512 goods. In terms of its total exports, India has a comparative advantage in 32% of its exports, which is the same as in 2000. India’s comparative advantage is concentrated on industries like agriculture, organic chemicals, cotton, iron, and steel, as well as accessories for clothing items rather than knit or crocheted items. The product category with the greatest comparative advantage is determined to be flat-rolled high-speed steel >/=600mm wide.

What this means is that the opportunity cost i.e., the cost of the next best alternative foregone for India to produce the above items is the least when compared to other countries.

For the sake of better understanding, If India can produce 80 units of cotton and 100 units of jute whereas another country can produce 100 units of cotton and 200 units of jute with a given set of resources, It is evident that even though the other nation has an absolute advantage in both cotton and jute; India has a comparative advantage in producing cotton since the opportunity cost for producing cotton in India is lower than the other nation.

How does comparative advantage help in determining the trade policy of a nation? This is where the Heckscher-Ohlin model of international economics comes into play which states that nations should export the goods and services they can create most effectively and in large quantities. The model emphasizes the export of goods requiring factors of production that a country has in abundance. It also emphasizes the import of goods that a nation cannot produce as efficiently. It takes the position that countries should ideally export materials and resources of which they have an excess, while proportionately importing those resources they need.

It then goes on to categorize resources into the binary of labor-intensive and capital-intensive and further explains that countries with relatively abundant labor and relatively scarce capital will typically export labor-intensive goods while importing capital-intensive goods. In contrast, countries with relatively abundant labor and relatively scarce capital will typically export capital-intensive goods while importing labor-intensive goods.

Some nations have a relatively high level of capital, which means that the average worker has access to a wide range of tools and machines to help with the job. These nations typically have high pay rates, which makes it more expensive to produce labor-intensive commodities like textiles, sporting goods, and basic consumer electronics than it would be in nations where there is a surplus of labor and low wage rates. Conversely, in nations with cheap and abundant capital, items like automobiles and chemicals that require a lot of capital, but little labor tend to be relatively inexpensive. Therefore, nations with a lot of capital should be able to create capital-intensive commodities cheaply and export them to cover the cost of importing goods that require a lot of labor.

According to the Heckscher-Ohlin theory, the amount of capital per worker rather than the total amount of capital is what matters. A small country like Luxembourg has much less capital in total than India, but Luxembourg has more capital per worker. Therefore, according to the Heckscher-Ohlin theory, Luxembourg will export capital-intensive goods to India and purchase labor-intensive goods in exchange.

Is this what happens in real life? Let us now dive deep into the trade practices of India to see if they are in alignment with the Heckscher-Ohlin theory and the concept of comparative advantage.

India exported goods worth $422 billion in the fiscal year 2021–2022 and services worth $250 billion during that same year. For the fiscal year 2021–2022, India’s top trading partners, as measured by the sum of their imports and exports, in billions of US dollars, were:

Source: Government of India

RankCountryExportsImportsTotal TradeTrade Balance
1United States76.1143.31119.4232.80
2 China21.2594.16115.41-72.91
3 United Arab Emirates28.1044.8072.90-16.7
4Saudi Arabia834.0042-28
5Russia1.0021.0022.00-20.00
6 Germany8.2113.6921.9-5.48
7 Hong Kong13.720.3434.04-6.64
8 Indonesia4.1215.0619.18-10.94
9South Korea4.8515.6520.5-10.8
10Malaysia3.719.0816.93-5.30
11 Singapore7.729.3116.93-1.59
12 Nigeria2.229.9516.36-11.00
13Belgium5.038.2616.33-5.29
14 Qatar0.909.0215.66-13.55
15Japan4.669.8515.52-4.75
16Iraq1.0010.8415.08-13.42
17 Kuwait1.254.9714.58-12.18
18United Kingdom8.835.1914.344.30
19 Iran2.786.2813.13-4.78
20 Australia3.268.9013.03-7.47
21Venezuela0.135.7011.99-11.47
22 South Africa3.595.9511.72-3.40
Remaining Countries126.78104.92231.7021.86
India’s Total422.08612.611034.69-192.0

India exports roughly 7500 different products to 192 different nations. The top 10 markets for Indian exports in 2019–2020 are listed in the table below.

RankCountryValue (US$ billion)Share of overall exports
1 United States57.716.94%
2United Arab Emirates28.89.20%
3China16.65.47%
4 Hong Kong10.93.53%
5Singapore8.92.90%
6United Kingdom8.72.80%
7Netherlands8.32.69%
8Germany8.292.65%
9Bangladesh8.202.61%
10  Nepal7.162.28%

India imports about 6000 different goods from 140 different nations.  The top 10 import sources for India in 2019–2020 are listed in the following table.

RankCountryValue (US$ billion)Share of overall imports
1China57.814.37%
2United States30.57.57%
3United Arab Emirates25.86.39%
4 Saudi Arabia23.05.70%
5 Russia214.91%
6Switzerland14.83.67%
7 Hong Kong14.63.63%
8South Korea13.23.28%
9Indonesia12.83.17%
10 Singapore12.23.02%

As can be seen from the data given above, India’s biggest export partners are developed countries which are capital intensive and thus require imports of products that are labor intensive. India’s population is its biggest asset, is, of course, a labor-intensive country and is exporting all the labor-intensive products to these countries with some exceptions like China and Bangladesh, which we will shortly circle back to while understanding the Leontief Paradox and the shortcomings of the Heckscher Ohlin model.

Similarly, if we look at the countries that India is importing from, there is a clear common thread of most of them being developed and capital-intensive countries that India does not have a comparative advantage in with the outlier here being China again.

India’s maximum number of exports to and imports from are with the United States which is arguably one of the most capital-intensive countries in the world. This is also in line with the Heckscher-Ohlin theory of trade.

It is reasonable to say at this point that the model does manifest itself in real life and was formulated after observing the real life for which Bertil Ohlin was even awarded the Nobel Prize in Economics in 1977.

However, despite its general plausibility, it is very important to note that the model is frequently at odds with the actual patterns of international trade. As the tables above depict, many patterns can be observed where the theory is falling apart. For example, India’s biggest importer is China despite it being a labor-intensive country. The list of India’s top ten exporters includes developing countries like China and Bangladesh which themselves are labor-intensive countries per se.

A Russian-born U S economist; Leontief was the first one to observe that the theory does not hold in a lot of situations. He argued that the United States was relatively well-endowed with capital. Therefore, the reasoning goes, the United States should export commodities that need a lot of capital and import goods that require a lot of labor. He discovered that the contrary was true: American exports typically require more labor than the kinds of goods that the country imports. The Leontief Paradox refers to these findings by him since they were the exact reverse of what the theory predicted.

A research paper from the faculty of California State Polytechnic University in Pomona in their findings about the Heckscher Ohlin model state that there is little evidence of a defined statistical relationship between India’s exports/imports ratio and its capital/labor ratio in today’s world. This does not mean that the theory has no relevance in explaining international trade between countries today. The limitations of a lack of more refined and cross-sectional data could have severely hampered the results and findings.

The Heckscher-Ohlin model has been put to test many times in the past and will yet again be put to test many times in the future.

 According to the literature, putting the theorem to the test with actual data has either yielded positive or negative results in terms of its predictive power. To explain international commerce, many economists have improved upon the original model and created additional theorems. Some of them have been successful, while others have not. However, the H-O model has always served as the fundamental framework. It has been the underlying building block to decoding patterns of trade in the world. This demonstrates that the H-O theorem is still pertinent to today’s economic debate and will continue to be employed in future studies of global commerce.

Regardless of the reasons, India’s prowess as a trading partner to many countries in the world has been consistently growing which showcases its potential to become a leader in the international trade arena in the coming years. Even though the BOP deficit continues to haunt us as a nation, especially in the wake of the pandemic that has just gone by and the fears of a recession looming soon, it is important to understand that for a developing country like India, taking little positive strides every day is the key. To be able to do this, we must keep trying to understand our strengths and weaknesses with the help of the theories explained above and make decisions basis that to emerge as an international economic power.

-Simran Soni

Junior Editor TJEF

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CLIMATEFLATION

These two words—climate change and inflation—are commonly read or heard in our environment. These now appear on every news article page, in every televised debate, in every corporate negotiation, in every board meeting, and in every conversation between two grocery store shopping women. The people’s dictionary has also been expanded with new words including climateflation, fossilflation, and greenflation. The temperature is rising along with the prices of commodities.

According to economists, the global inflation problem is a result of the supply-side phenomenon, which is simpler to manage because businesses can respond to increased demand by raising their supply. Cost-push inflation, or supply-side inflation, is another name for it. On the other hand, demand-side inflation (also known as demand-pull inflation), arises when consumer demand increases more quickly than the rate at which the supply of commodities increases. It takes place when the cost of getting goods and services to market rises.

WORLD INFLATION RATE (Source: The World Bank)

But can supply-side inflation be reduced with ease? Even if it could be simple, the root cause must be addressed rather than taking actions based on symptoms. If we claim that climate change is the primary factor causing inflation, we won’t be mistaken.

Inflation is discreetly fuelled by climate change. Let’s move forward incrementally. Higher energy costs and growing prices for unprocessed food are to blame for the inflation we are currently seeing. At present, people claim that the two are a consequence of the Ukraine conflict and the economic sanctions that the West and other democracies have levied on Russia. The claim is in fact, true on many grounds. Because of the conflict in Ukraine, many nations will have to rely less on Russian oil and gas imports. Then how will countries, especially European, survive without oil and produce energy. This will speed Europe’s transition to a greener economy. Let us question again- Will that impact inflation?

“The more urgent and faster the green transition becomes, the more expensive it will turn out to be.”

It is no surprise that the government is hesitant to implement policies like taxing carbon emissions or enacting financial rules to manage climate risks because doing so will result in increased costs for companies that produce energy, which will then be passed on to consumers.

In the coming decade or so, as nations around the world work to meet their commitments to reduce carbon emissions, the development of new green technologies and products that would aid in doing so will rely on materials, such as minerals and metals (such as copper, lithium and cobalt) whose supply is unlikely to grow in line with the increase in demand for them. The result will be “greenflation.”

It is important to note that there are numerous ways in which climate change might affect energy demand. The energy demand is first increased by events like a March heatwave or a winter that was colder than usual. Both the occurrence of extreme weather events and temperatures are rising. An intense change in temperature reduces productivity in humans which impacts the efficiency of the businesses. To ensure that firms and industries are operating efficiently and delivering same or rather increased output, management have to pay extra to the employees. This cost again gets debited from the customer’s account.

Second, before renewables reach their full potential, there will likely be a transition period during which power derived from fossil fuels is disincentivized. Energy prices may fluctuate significantly during this time.

Weather-related surprises are becoming more frequent, making it more difficult than ever to forecast India’s inflation patterns. Therefore, it is not surprising that inflation forecasting errors are increasing.

A heatwave in March 2022 wreaked havoc on the wheat harvest and compelled the government to impose a moratorium on wheat exports at a time when demand was rising globally. With periods of out-of-season rainfall and shifting monsoon patterns taking hold, we discover that rains have grown more unpredictable and deviate further from the average than they did before.

“India faces risks from the agriculture sector’s vulnerability to climate change, which could affect food inflation, as extreme weather events lead to volatility in food prices, especially of fruits and vegetables” – CRISIL

Sowing procedures may alter as a result of shifting rainfall and reservoir patterns. This, even momentarily, puts food crops under inflationary pressure. The occurrences have the potential to decrease the portion of farms that is suitable for growing crops, thwart productivity for extended periods, and raise operating costs for the land, including the price of financing, necessary infrastructure upgrades, and higher insurance and insurance premiums.

Global food prices reportedly reached their highest point ever in March 2022, according to the UN Food and Agriculture Organization (FAO). Although they were 0.8% below their peak in April, the price of the reference basket of widely traded food items was 29.8% higher than it was a year ago.

Power plant damage from hurricanes might result in a lack of energy. Homebuilding prices can increase and be destroyed by wildfires. The precise effect that harsh weather has on inflation is still being studied in depth. Agriculture prices, for example, are one change that is simpler to measure than other changes, such changes in labour productivity.

Food and energy inflation, key factors in the current uptick in total inflation, could become permanent as a result of climate change. Doing a Y-o-Y analysis, GDP growth dropped to 6.3% in quarter two of the fiscal year 2023 from 8.4% in the second quarter of the year 2022.

Increased global commodity prices and the rupee’s decline to a historic low had an effect on company profitability. Retail inflation fell to a three-month low of 6.7% in October after a prolonged period of hovering over 7%, although it was still above the RBI’s upper tolerance band of 6%. After 19 months, overall inflation began to decline to single digit.

Chief Economic Advisor V Anantha Nageswaran said- “Domestic inflation is expected to ease further back on the back of softening global commodity prices and expectation of good rabi crop.” That trend is unlikely to continue given the gloomy long-term picture for climate change.

According to an SBI Ecowrap analysis, despite a 28% increase in revenues, the operational earnings of 3000 listed businesses fell by 14% in Q2 FY 2023 y-o-y.

India may inevitably require an integrated institutional structure connecting the various aspects of policymaking to manage the rising volatility brought on by climate change and the shift to cleaner energy sources.

-Swati Shubham
Senior Editor, TJEF