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

Advertisement

The Washington Consensus: Steps to build an economy?

Imagine being in charge of a country which has undergone a rapid change for the worse in terms of an economic standpoint. It is definitely difficult to get the country back on track. Because of the help of the IMF and the World Bank you can now start afresh. However, it is still confusing about what has to be done to build your economy from scratch. Thankfully there are a set of rules to help you in this endeavor in setting up a self-sufficient economy known as the Washington Consensus. So let us find out what it is and how it functions.

What is the Washington Consensus?

John Williamson, an economist, first used the term “Washington Consensus” in 1989. He was discussing a set of measures that had gained acceptance among Latin American politicians in reaction to the early to mid-1980s macroeconomic unrest and debt crisis. In order to aid in the recovery from the debt crisis, these measures were also supported by specialists in Washington’s international institutions, particularly the International Monetary Fund and the World Bank as well as the US Treasury.

A note of caution, these rules are only meant to be descriptive and not prescriptive, which means that these rules do not guarantee the economy to be a success. Definitely there will have to be some considerations taken in place depending on the scenario of the country and what can actually be done depending on the ability of the government.

Maintaining fiscal restraint, reallocating public spending priorities (from subsidies to health and education spending), reforming tax law, letting the market determine interest rates, upholding a competitive exchange rate, liberalising trade, allowing inward foreign investment, privatising state enterprises, removing barriers to entry and exit, and protecting property rights are among the main Washington Consensus policies. Williamson pointed out that these policies went against what was believed to be true in developing nations, many of which adopted state-dominated systems in the 1950s.

The 10 rules of the Washington Consensus

  • Reduce national budget deficits

Large budget deficits lead to high variable tax rates. To counteract this, it was suggested to observe fiscal discipline either by raising tax revenues or by reducing domestic spending to reduce the amount of spending done by the government.

  • Redirect spending from politically popular areas toward neglected fields with high economic returns

Some aspects of public spending, such as subsidies to state-owned businesses or for the purchase of food or fuel, caused economic distortions and favored wealthier urban people over the impoverished in rural areas. Reducing subsidies for politically connected economic sectors may cost some people money, but it frees up funds for expenditure on infrastructure, education, and fundamental social services.

  • Reform the tax system

Reforms should enlarge the tax base and eliminate the exclusions that exempt some people and organizations with political ties from paying taxes. Taxation that is more inclusive and straightforward can boost productivity, increase tax revenue, and lessen tax evasion.

  • Liberalize the financial sector with the goal of market-determined interest rates

Government interest rate regulations typically penalize savers, deter investment, and stifle financial progress; restricting credit typically encourages corruption and benefits political insiders. Market-based interest rates encourage saving and ensuring that banks or the financial sector, not politicians in the government, decide how much credit is given out.

  • Adopt a competitive single exchange rate

A competitive, market-driven exchange rate can encourage export-led economic growth and alleviate balance of payments issues; avoid inflated exchange rates that deter exports and cause currency rationing.

  • Reduce trade restrictions

Trade barriers that support particular interests should be eased generally. Tariffs are better to quotas and other arbitrary trade restrictions that stifle trade since they allow for progressive reduction, local enterprises to adapt, and produce money for the government as opposed to quota rents for special interests.

  • Abolish barriers to foreign direct investment

Foreign investment that is prohibited or restricted at home gives monopolies to native companies and lessens competition. A country can increase its capital, create jobs, and develop its workforce through foreign investment, but also increasing competition for native businesses. Domestic businesses that attract FDI can encourage intellectual property breakthroughs that advance development.

  • Privatize state-owned enterprises

State-owned businesses frequently operate inefficiently and rely on subsidies from the government, which increase countries’ fiscal deficits. While some unemployment may result from privatization, these changes are more likely to boost firm productivity and profitability.

  • Abolish policies that restrict competition

Removing regulations and obstacles that prevent new firms from entering the marketplace can stimulate competition, efficiency, and economic growth.

  • Provide secure, affordable property rights

Investment and individual liberty are encouraged by a legal system that awards and preserves property rights, including the rights of those who hold land without legal documentation and work undocumented jobs in the informal sector. Owners can obtain financing thanks to private assets, which grows the economy and the revenue base of the government.

Effects of the Washington Consensus

By the middle of the 1990s, the benefits had mainly fallen short of expectations, especially in Latin America, where reforms had been pursued with particular zeal. The Washington Consensus was expanded to prescribe a longer list of adjustments in response, which is evident in the increasing number of terms and conditions associated with IMF and World Bank loans.

However, sluggish development, recurrent fiscal crises, and widening inequality cast doubt on the success of the entire project, severely harming the Washington Consensus’ political reputation. A new wave of leftist governments appeared in Latin America in the 2000s, many of which ran on platforms promising to reverse these regulations.

Major Criticisms

  1. Free trade is not necessarily advantageous for emerging economies, according to some economists. To ensure long-term prosperity, several strategic and young industries must first be preserved. These businesses can also need protection from imports in the form of subsidies or taxes.
  2. Government assistance has allowed Chinese businesses to make significant investments in Asia, Latin America, and Africa’s developing nations. These businesses frequently make infrastructural investments, opening doors for long-term trade and growth.
  3. Privatization can boost output and raise the standard of the good or service. Privatization, however, frequently causes businesses to disregard specific low-income segments or the social demands of a rising economy.

Conclusion

There can never be a fixed set of rules that even by theory can help to build a self-sufficient economy, the short-term impacts of these rules did not help the targeted economies, however it helped them build a strong base on which these economies can stay stable and thus helped the long-term growth of these economies. Any sets of rules can only be descriptive and not prescriptive for an economy, as each economy in itself is unique and all require different solutions for them to get through their problems. Sure, these rules could be taken as an outline, but definitely not the guidebook to build an economy.

Abishek Jeremy Lobo

Editor, TJEF

References

  1. https://www.piie.com/blogs/realtime-economic-issues-watch/what-washington-consensus
  2. https://www.piie.com/commentary/speeches-papers/washington-consensus-policy-prescription-development
  3. https://www.washingtonpost.com/politics/2021/04/16/people-have-long-predicted-collapse-washington-consensus-it-keeps-reappearing-under-new-guises/
  4. https://www.intelligenteconomist.com/washington-consensus/