India, RCEP and economic theory

As things stand, the RCEP is dead in the water without India and can not last as an effective trading bloc

There has been a lot of criticism of India’s refusal to be a part of RCEP, the Asian trade bloc sponsored by China. India will never become an efficient manufacturer, say the critics.

There has also been a lot of support for India’s decision. Indian manufacturing will die if it joins the RCEP, goes this argument. The two sides can argue till the cows come home. It will make no difference.

But let me say this at the very outset: staying out of RCEP doesn’t mean that India is about to become an autarky, which is what the critics are assuming. Joining RCEP will not make India a great manufacturing nation, either.

That said, I want to ask a question that has remained unanswered since I first raised it in class 49 years ago: is comparative advantage a cause, or a consequence, of international trade?

It is assumed by all proponents of a low or zero tariff trading system that comparative advantage is caused by international trade. Is it, now? Really? Is there any evidence for this directional causality?

Gains vs terms

Modern trade theory is based on David Ricardo’s work, and he said trade was a consequence of comparative advantage. He did not say that comparative advantage was a consequence of trade.

To the best of my limited knowledge subsequent theoretical work, mostly in the 20th century by American economists, has remained also silent on causality. So even today, 203 years after Ricardo wrote about comparative advantage and international trade, we don’t know the answer to the direction of causality.

The other strand of the ‘Join RCEP’ argument is based on what is called the ‘gains from trade’ theory. This says that more trade is better than less trade; which is better than no trade; because trade increases national income. This increase is the gain.

However, these gains are extremely difficult, if not impossible to measure because of the disaggregation problem: you don’t know which thing contributed how much to the increase. Labour costs, efficient logistics, infrastructure, currency manipulation etc. This, when you think about it, precisely characterises Chinese exports, which play such a major role in its national income.

So we have the other theory. It focuses on what is called ‘terms of trade’. This is the ratio of export prices to import prices. That is, it tells how much you can import for one unit of exports. Clearly, this is not dependent on the volume of exports.

Thus, in theory, you can export just the last unit on earth of something absolutely essential to the highest bidder. In theory he or she will pay so much that it pays for all your imports.

The China factor

Truth be told, what we know is that China is not a trading nation; it is a selling nation. It prices its exports cheaper than others.

But it is a long stretch to assume that this is because it is an efficient producer. We have no idea of the structure of its costs. Indeed, Chinese producers get so much help from the government that all international trade theory becomes nonsensical.

That’s why India has done the right thing in staying out. RCEP is 75 per cent China and 25 per cent the others – who, moreover, don’t have the military muscle to block China’s practices. History shows that trade is always backstopped by force.

As things stand, I will predict that RCEP is dead in the water without India. It cannot last as an effective trade block. It is not the only option its non-China members have.

Indeed, why else would China allow a treaty that says to India “Yo, man, you can join later?” That invitation alone is enough to tell you who has got the upper hand. Twitter: @tca_tca