The sharp increase in the current account deficit (CAD) is ringing alarm bells. But it is a mere reflection of the postponement of 21st century trade reforms (TCTR) that have held India back from emerging as a major player in the global economy, with the shares of trade and investment far below their true potential. India has not kept pace with the changes in the global trade scene - increasing emphases on linking with global and regional supply chains, and diversification into new areas of services trade. These call for a robust set of reforms in services trade, trade facilitation, and a strategic focus on regionalism. Drastic reduction in transaction costs through trade facilitation reforms is also essential to improve the business environment to attract larger and steadier inflows of FDI to supplement the needed investment for a high and sustained growth.
Finance Minister P Chidambaram has recently emphasised attracting larger inflows of FDI as a panacea for the CAD problem. But that is not guaranteed given persistent acute problems in the ease of doing business in India, as reflected in the country's poor global rankings on relevant surveys. Moreover in the true definition of FDI, where investors need to have a stake of at least 10 per cent in the voting stock, the present FDI inflows are minuscule in comparison with inflows of Foreign Institutional Investors (FII). It is heartening to know that Mr Chidambaram has recently constituted a committee to sort out the differences between the two in a scientific manner. True FDI inflows are more desirable since these represent a vote of confidence by foreign investors in India's competitiveness and ability to sustain growth. For FIIs, economic crises in Asia in the 1990s are itself enough to remind us that a large proportion of portfolio inflows represents speculation on market sentiments rather than confidence in the longer-term fundamentals of economic growth and competitiveness. If our CAD is increasingly financed by fresh capital flows represented by debt and portfolio investment, the country will become prey to a vicious cycle, as interest payments on such debt and repatriation of dividend income would represent substantial outflows of foreign exchange. Any sign of volatility would also see an exodus of such funds creating a crisis.
The high CAD and the high share of portfolio investments point to two very disturbing trends. The first is India's inability to become a major global exporter; and the second is its inability to attract FDI in manufacturing- and services-related industries that directly create jobs. The two are interrelated. FDI has played a major role in bringing in technology, best practices and branding to the export-oriented manufacturing hubs of emerging Asia: China, Malaysia, Thailand, and Korea. Such FDI also helped build cross-border relationships leading to integrated production networks that have boosted competitiveness and created millions of jobs. It has also catalysed domestic investment, creating business opportunities for SMEs to become dedicated suppliers to large FDI -based manufacturing units across such production networks. But participating in global production networks, and attracting such efficiency-seeking FDI requires a strategic focus on reducing transaction costs of operations and ensuring market access.
Key points of my earlier pieces on trade facilitation and reducing transaction costs need reiteration. These are a) comprehensive move towards paperless environment for the import-export process, b) reduction in bureaucratic discretion and ensuring greater transparency in all regulatory aspects governing trade and manufacturing, c) harmonisation of key regulations governing manufacturing across states, starting with the implementation of an effective GST, and d) strong governance and monitoring mechanism related to transaction costs at the highest level of government.
It is important for policymakers to understand that high trade transaction costs negatively impact the competitiveness of those players in the international system that operate with smaller margins and capital bases. This means that SMEs are the ones hardest hit in the absence of meaningful trade facilitation efforts. Since a large number of Indian manufacturers in key labour-intensive sectors like textiles, leather, chemicals, and gems and jewellery belong to the SME category, high transaction costs can ensure that such manufacturers face difficulties in entering the international market, and thus never get the opportunity to increase in scale and technology. The lost opportunities in terms of both employment and economic growth for India are costly.
TCTR need also to prioritise two critical policy areas: professional services and focused regionalism that ensure India Inc's integration into international production networks. Indian trade policy in services became IT-centric with an over-emphasis in its trade negotiation priorities on Mode 4 (or liberalisation of the movement of people), a critical demand of the Indian IT lobby. In doing so, it did not focus on the barriers preventing the take-off of other services such as behind-the-border regulatory restrictions on accounting, legal, engineering, architecture, or health related professional services in partner countries. It also paid little attention to emerging issues in data privacy and data restrictions which are becoming increasingly important. The lack of reforms and liberalisation in services like accounting and legal services have prevented Indian professionals from effectively participating in global networks of firms through which these services are offered. Regulations restricting Indian firms from incorporating (by only mandating partnerships as a form of business); offering single-window services (by not allowing association between different types of professionals); and advertising and soliciting business have prevented them from attaining economies of scale and global ambitions. A firm mandate towards reform-oriented regulation of professional services with a view to making them globally competitive, and a trade and export promotion policy designed to make India a professional and knowledge services hub, are essential if India is to look beyond IT services.
Strategic regionalism would require India to focus on Asia, especially greater southern Asia that includes most of the ASEAN member states. The ultimate objective would be to integrate the product, services, financial, and energy markets of southern Asia, creating opportunities for competitive production networks, integrated energy grids, and the creation of a consumer market with over 600 million middle-class consumers by 2020. The road to such integration lies through innovative trade policy that focuses on essentials such as physical connectivity between markets, addressing non-tariff barriers, and complete eradication of tariff barriers - all leading to strong regional supply chains with full Indian participation. Instead our trade-policy establishment is dissipating its energy on agreements with developed countries like the EU where market access gains will be marginal at best, or in forums such as the BRICS that add little value to furthering India's economic objectives. Regionalism is promoted in an ad hoc fashion since the ministry of external affairs and the ministry of commerce do not collaborate with each other to develop India's regionalism strategy.
It is high time that the government seriously implements 21st century trade reforms. That is the only viable and sustainable option left in terms of policy to deal with the challenge of CAD, and promote large inflows of true FDI to sustain high outward-oriented growth.
The writer is a trade economist who served as economic adviser in the ministry of commerce from 1988 to 1993
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