India’s Foreign Trade Strategy for Economic Growth | Economics

Trade policy plays an important role in achieving the objectives of rapid economic growth and self-reliance. It is on the basis of these static and dynamic gains of trade that case for free trade or liberalisation of trade has been built. When a country specialises on the basis of its comparative cost or production efficiency and export and import accordingly, it enables it to make optimum use and allocation of its resources. As a result, output, income and welfare of its people increase.

These gains emanating from trade through improved allocation of given resources of a country are generally described as static gains. Thus, Professor Haberler writes, “International division of labour and international trade which enable every country to specialise and to export those things which it can produce in exchange for what others can provide at a lower cost have been and still are one of the basic factors promoting economic well-being and increasing national income of every participating country.”

However, importance of trade is not confined to static gains flowing from improved allocation of the given resources. Foreign trade also promotes economic growth of a country. It is the beneficial effect of trade on economic growth that is described as dynamic gains. D.H. Robertson described foreign trade as “an engine of growth”. With grate income and production made possible by specialisation and trade, greater savings and investment become possible and as a result higher rate of economic growth can be achieved.

Through promotion of exports, a developing country can earn valuable foreign exchange which it can use for imports of capital equipment and raw materials which are so essential for economic growth. To quote Haberler again, “The higher the level of output, the easier it is to escape the ‘vicious circle’ of poverty and to ‘take off into self-sustained growth’ to use the jargon of modern development theory. Hence, if trade raises the level of income, it also promotes economic development.”

Elaborating how trade promotes growth he emphasises the following factors:

1. Through foreign trade developing countries can get material resources such as capital equip­ment, machinery and raw materials which are so essential for industrial growth.

2. The developing countries through trade can import and use superior technology which has been invented in advanced developed countries and is embodied in the machines, capital equipment which they import.

3. Foreign trade enables the transmission of technical know-how, skills, and managerial talents to the developing countries.

India’s Trade Strategy of Import Substitution:

As we began our planning for development, the two options were open to us with regard to our foreign trade policy. First, we should lay stress on export promotion in our strategy of development for accelerating economic growth. The second option was to adopt import substitution as a major element of our trade policy. Note that the second policy of import substitution does not emphasise the role of foreign trade for accelerating economic growth.

In fact, the policy of import-substitution was adopted in view of the perceived bleak prospects of raising India’s exports. When exports could not be increased substantially, we could not pay for imports on a large scale. Therefore, India’s strategy of industrialisation was based on substitution of imports rather than export-oriented trade policy. The policy of import substitution for promoting growth was also thought to be quite feasible in view of India’s vast domestic market.

It is clear from above that India adopted the policy of import-substitution because of what is now called export-pessimism. In fact, in the nineteen fifties and sixties export pessimism characterised the thinking of most development economists. For example, Raul Prebisch postulated that the terms of trade of developing countries have a tendency to deteriorate over time regardless of the policies of developing countries. Prebisch’s postulate was based on three grounds.

First, demand for primary products which underdeveloped countries were exporting, were income-inelastic. Second, technological progress that was taking place in developed countries was of the nature that saved the use of raw materials which underdeveloped countries were exporting. Third, because of the prevailing monopolies in the manufacturing industries of the developed countries, the prices of their manufactured products were relatively higher than the prices of primary and agricultural products whose production and sale were being done under competitive conditions. Thus, according to Prebisch, export expansion by developing countries was quite unprofitable.

Similarly, R. Nurkse, another pioneer in development economics, believed that for the newly emerging countries like India foreign trade could no longer serve as ‘engine of growth’. Nurkse’s export pessimism arose from his belief that foreign market could not absorb imports on a sufficient scale as developing countries accelerated their process of economic growth. In view of this external environment, Nurkse concluded that in order to accelerate growth developing countries should un­dertake a balanced pattern of investment in a number of different industries so that they can generate mutual demand for each other’s product leading to the expansion in size of home market.

To quote Nurkse, “When developing countries face difficulties in exporting both traditional and new exports, import-substitution strategy may be adopted by them as an escape route from stagnation.” Nurkse further writes, “International trade cannot now be an effective engine of ‘economic growth’ and in the strategy of growth, underdeveloped countries have of necessity to lay emphasis on ‘balanced growth’ – a coordinated development of local industries in accordance with the growth and structure of domestic demand.”

It is interesting to note here that our former Prime Minister, Dr. Manmohan Singh, was perhaps the first economist who challenged this export pessimism of early development economists, espe­cially in the context of India. On the basis of his empirical findings about the export potential of the Indian economy, he concluded that it was not easy to meet the increase in import requirements in raising the rate of economic growth by any other means but export promotion.

Arguing the case for export-promotion policy of development he writes, ”Whatever the development strategy, the function of international trade as a supplier of ‘material means indispensable for development’ is likely to retain its importance for most underdeveloped countries in their quest for higher rates of economic growth. Imports, however, have to be paid for either by current export earnings or by withdrawal from reserves of foreign exchange or by fresh capital inflows. The withdrawal from reserves is not unlimited process, capital inflows ultimately lead to higher service charges and repayment obliga­tions. In the long run, therefore, the import capacity of an economy and its ability to utilise the benefits of international trade is crucially dependent on its export capacity. ”

But Dr. Manmohan Singh not only highlighted the need for export promotion for accelerating economic growth but with his empirical study he demonstrated in India’s case that export promotion to meet the growing needs for imports was in fact possible and that the stagnation of India’s exports during 1951-61 was partly a consequence of faulty Indian economic policies. Commenting on Dr. Manmohan Singh’s work, Prof. Amartya Sen writes, “Rapid increase in exports would be impossible if export pessimism prevailing at that time was well-grounded.” And Professor Sen himself answers that “with its very careful and painstaking empirical arguments, Dr. Manmohan Singh demonstrated that it was not so well grounded after all.”

Empirically, the export pessimism of the nineteen fifties (Post-War Period) has been proved to be untrue and unjustified. World trade in the nineteen fifties and sixties grew faster than world income. Several developing countries used export promotion as a means of attaining a fast economic growth. In the early 1960s Japan was the shining example of using export promotion strategy to achieve a fast rate of economic growth, beginning from a state of underdevelopment.

Japanese growth experience is often described as Japanese miracle. In the later period, other success stories of achieving high growth through outward-looking strategy of development have been of Asian countries of South Korea Taiwan, China, Thailand, Singapore and Hong Kong. Owing to their rapid economic growth in nineteen seventies and eighties they have been called ‘Asian Tigers’. It is also worth mentioning that the expansion in exports of developing countries which have used export promotion as a strategy of growth has not been confined to primary products such as fuel and agricultural products (food, agricultural raw materials). As a matter of fact, there has been significant change in the composition of exports of developing countries towards manufacturers.

It may be noted that in the nineteen fifties and early sixties free trade was opposed on political grounds also. Fears were expressed that through free trade industrial developed countries would ac­quire political domination, as happened in case of India. East India Company of Britain which came to India for trading acquired political domination. It may however be noted such fears of political domination through trade have now receded in the present political context. In fact, the protection­ist sentiment is now stronger in the developed countries such as US and EU. There is now huge cry in USA for protecting American jobs by banning outsourcing of business services (BPO) to India.

The success in export promotion accelerates economic growth of a country. The emergence of Japan and Germany and recently China as major economic powers has shown that their success in export expansion made them economically more independent and strong. On the other hand, develop­ing countries like India which followed import-substitution strategy had to face recurrent balance of payments crises and the persistence of huge external debt problem which made them more dependent on developed countries and international institutions such as IMF and World Bank.

For at least up to 1980, India adopted a trade strategy of import substitution. The choice of this policy was based on export pessimism which led the Indian planners to believe that export earnings of India cannot be increased. The choice of this inward-looking strategy was further strengthened by the vast size of Indian domestic market To implement this trade policy of import substitution the imports of several commodities into India were banned and quantitative restrictions on some other commodities were imposed.

Besides, to give protection to the domestic industries, customs duties were levied on a number of commodities to discourage their imports by raising their prices. The customs duties levied in India on certain commodities were as high as 200 per cent or 150 per cent which were one of the highest in the world. In addition to these, the import-licensing was used so as to regulate the quantities of some essential goods and raw materials that could be imported and accordingly licenses for import quotas were issued by the Government.

A scheme of import- licensing in case of certain commodities was introduced under which imports were permitted to the extent that domestic production fell short of domestic demand. Further, stringent foreign exchange regulations were introduced and foreign exchange was released to the holders of import licences for importing specific commodities.

It may be noted that India’s policy of import substitution was indiscriminate and also continued for quite a long period. This is unlike some other countries such as Japan and South Korea which adopted import substitution only for some period of time and that too in case of selected commodities for which they had potential comparative advantage.

Results of Import-Substitution Policy:

However, it may be noted that policy of import substitution contributed significantly to industrial growth between 1956-66. But several weaknesses of the policy of import substitution became evident during the course of time. First, the policy-makers underestimated the possibilities of expansion in exports. As in the path-breaking study about the trends in exports, Dr. Manmohan Singh found that a lot of export possibilities were lost due to faulty trade policies. As a result, India’s share of world exports declined from about 2 per cent in 1951 to about 0.53 per cent in 1992.

Second, policy of import substitution underestimated the import intensity of import substitution process itself. Growth of import-substituting industries required large quantities of imports of capital goods, machines, raw materials etc. As a consequence, whereas imports increased substantially there was no adequate growth in exports resulting in balance of payments problems. In 1966 we had to devalue the rupee to promote exports and discourage imports in order to solve balance of payments problem. However, 1966 devaluation did not succeed in improving the trade deficit.

It may be noted that deficit in balance of payments which arose mainly due to import-substitution policy forced Indian policy-makers to make some changes in attitude towards exports. Accordingly, in the Third Plan period (1961-66) and the Fourth Plan period (1969-74) several export promotion measures (including devaluation of 1966) were taken. However, as has been correctly pointed out by C. Rangarajan that “Until the end of 1970s, exports were primarily regarded as a source of foreign exchange rather than as an efficient means of allocating resources. Import substitution remained the basic premise of the development strategy.”

Since import-substituting industrialisation was pursued regardless of comparative cost considerations, inefficiencies crept into the system resulting in the Indian economy becoming increasingly high-cost economy. This high cost and inefficiency in production was an important reason for poor export performance despite the various incentives and concessions given by the Government for export promotion.

India’s Trade Strategy – Import Liberalisation and Export Orientation:

There was a severe economic crisis in 1991. This economic crisis had its root in persistent deficits in balance of payments in the last several years. Gulf war of 1990 added to the problem as it resulted in shooting up of oil prices which required enhanced spending in terms of foreign exchange. By March 1991, current account deficit in balance of payments reached a record level of about 10 billion US dollars or over 3 per cent of our GDR Exports were declining.

Foreign borrowing in last several years raised the ratio of short-term debit to foreign exchange reserves to an extremely high level of 146.5 per cent. Foreign debit reserve ratio rose to a peak of 35.5 per cent. As a result, our foreign exchange reserves dwindled to a meagre amount which was hardly adequate to meet only a few weeks imports. A default on payments for the first time in our history became a distinct possibility in June 1991. Foreign capital was flying from India. No one was willing to lend us anymore.

The severe economic crisis of 1991 forced us to make drastic reforms in trade policy. Fortu­nately, Dr. Manmohan Singh was appointed as Finance Minister. Since then many far-reaching reforms in trade policy have been undertaken. Though some liberalisation of trade policy was undertaken in the 1980s, a truly liberalised trade policy was adopted from 1991 onwards.

The liberalisation of trade policy in India is characterised by two important features:

1. Import liberalisation and

2. Export orientation of trade policy.

This new trade policy has accelerated India’s transition to a globally oriented economy by stimulating exports and facilitating imports of essential inputs and capital goods. Steps were taken to promote exports by removing anti-export bias in the earlier policy. This policy of import liberalisation and export-orientation was in fact the policy that was recommended by IMF and World Bank to solve the balance of payments problem facing the developing countries and to accelerate rate of economic growth. We explain below this trade policy in some detail.

1. Import Liberalisation in Economic Reforms of 1991:

The first important reform in India’s trade policy has been the elimination of quantitative restrictions in a phased manner on most of intermediate and capital goods since 1991. Secondly, prior to 1991 imports were regulated by means of a positive list of freely importable items. Instead, since 1992 as a part of trade policy reforms only a short negative list of imports is subject to regulations by Government. Other goods can be imported, subject of course to payment of duty.

Abolition of Licensing:

Prior to 1991 a large number of goods were subject to import-licensing restrictions. Now, most of the items of imports have been put on Open General License (OGL). That is, for their imports prior approval or license from any authority is not required. Thus, License -Permit Raj regarding imports has been done away with.

Tariff Reduction:

An important step towards import liberalisation has been reduction in import duties to eliminate protection given to domestic industries from foreign competition. The maximum import duty which was as high as around 150 per cent was reduced to 110 per cent in 1992-93. This was further reduced to 85 per cent in 1993-94, to 65 per cent in 1994-95 and to 50 per cent in 1995-96. In 2004-05 average customs duty had been reduced to 20 per cent only.

Empirical evidence shows reduction in protection increases efficiency and productivity in the domestic industries as it exposes them to foreign competition.

Liberalisation of Imports of Gold and Silver:

Another significant import liberalisation has been that imports of gold and silver have been liberalised. This has helped in preventing smuggling of these metals.

Critique of Import Liberalisation:

It may be noted that fears were expressed about import liberalisation both by certain politicians and economists, especially with Leftist leanings. They contended that import liberalisation would kill domestic industries as they would not be able to compete with the cheap foreign products. This would lead to closure of a large number of industrial units, especially small-scale industries. Besides, they claimed that large-scale imports would require substantial foreign exchange resources.

Thus, according to them, import liberalisation would worsen the balance of payments problem rather than solving it. Even a reputed economist, Dr. Bimal Jalan, a former Governor of Reserve Bank of India, expressed reservations about the policy of import liberalisation and pointed out that it would be highly risky for the Indian economy.

Writing in 1991, he says, “Given the balance of payments constraints operating now, and the financing options currently available, import-liberalisation as strategy does not seem to be a feasible option over the next few years. This pragmatic view is not dependent on the theoretical validity (or otherwise) of the liberalisation argument. By implication, import liberalisation would have the effect of raising, even in the short run, the ratio of import to GDP. This may not be undesirable in itself, but it would require larger inflows of external capital in the next few years and this is not available on appropriate terms. Past experience shows that further commercial borrowing to finance import liberalisation would also be undesirable, given the high level of external debt. In this situation, import liberalisation would be unduly risky and could lead to a repetition of the unfortunate experiences of several other developing countries.”

However, in actual experience, these fears about import-liberalisation leading to adverse consequences have not proved to be true.

2. Export Orientation of India’s Trade Policy:

Along with import liberalisation, export-orientation was also given to India’s trade policy pursued since 1991. In other words, for the first time greater emphasis was placed on export promotion in our trade policy by removing anti-export bias of our earlier policy. Some economists describe it as outward-looking strategy which was adopted since 1991 in place of inward-looking strategy of import substitution followed earlier.

Following are the various export-promotion measures taken to give export orientation to trade policy:

i. Reduction in Customs Duties to end Anti-Export Bias:

Prior to 1991 customs duties of India were the highest in the world and were levied to promote import substitution. These very high customs duties provided a high degree of protection to domestic industries. In actual practice, the high degree of protection lowers efficiency and is not conducive to optimum use and allocation of resources. In the absence of competition from imported products, the prices of domestic goods were high and this served to induce import substitution but worked against promotion for exports. Since prices of products in international markets were lower, it was not profitable to produce for export. Therefore, to remove this anti-export bias and promote the growth of exports, custom duties were reduced and in 2004-05, average rate of customs duties has been reduced to 20 per cent.

ii. Devaluation of Rupee:

Another important step to promote exports was devaluation of rupee by 20 per cent in July 1991. Devaluation lowered the prices of our exports and gave an important boost to them. Prior to 1991 rupee currency was overvalued and to ensure growth in exports to make some foreign exchange earnings, export subsidy in the form of cash compensatory allowance was provided to exporters. Therefore, along with devaluation cash compensation allowance was withdrawn.

Market – Determined Exchange Rate – Convertibility of Rupee:

After two years of reforms in 1993, exchange rate of rupee was made market determined, that is, exchange rate of rupee with foreign currencies was left to be determined by demand for and supply of rupee and other currencies. This implies that rupee can appreciate or depreciate in terms of other currencies every day depending on demand and supply conditions. This flexible exchange rate works to some extent to correct disequilibrium in the balance of payments. However, it is worth mentioning that exchange rate though determined by demand for and supply of foreign exchange can be influenced by RBI through buying and selling of dollars and other foreign currencies in the foreign exchange market. Therefore, present exchange rate system is more correctly described as managed float.

It may be noted that over a period of time since 1993, exchange rate of rupee has declined, that is, rupee has depreciated. This has tended to promote exports and discourage imports. In addition to the introduction of market-determined exchange rate rupee has been made convertible on current account of balance of payments, that is, importers can now get their rupees converted into dollars and exporters can sell their dollars for rupees at market-determined exchange rate. Thus, convertibility of rupee has facilitated imports and exports and has contributed to the globalisation of the Indian economy.

iii. Liberalisation of Control over Exports:

Through continuous review and revisions during the last 20 years controls on exports has been liberalised to the extent that now all goods may be exported without any restriction except the few items mentioned in the negative list of exports. The items in the negative list of exports are regulated because of strategic considerations, environmental and ecological grounds, essential domestic requirements, employment generation and on account of socio-cultural heritage.

iv. Duty-Free Import of Capital Goods for Use in Production for Exports:

A significant export- promoting measure is that capital goods meant to be used for production of exportable products can be imported free of customs duty. There are two windows to fulfill export obligation on FOB (free on board) and NFE (net foreign exchange) basis.

v. Advance Licenses for Imports against Exports:

Advance licenses which are used to import specified raw materials without payment of any customs duty against confirmed export order and/or letter of credit have been made transferable after export obligation has been fulfilled.

vi. Exemption from Tax and Credit Subsidies:

Profits or incomes from exports are completely exempt from income tea. Besides, exporters are provided preferential access to credit from banks. Concessional rates of interest are charged for pre-ship and post-ship credit to exporters.

vii. The Duty Drawback Scheme:

In this important scheme of providing incentives to exporters customs duty and excise duty paid on inputs which are used for production of exports are reimbursed to exporters.

viii. Incentive to Exports of Services:

In an attempt to provide massive thrust to export of services EXIM Policy 2003-04 has introduced duty-free import facility for the service sector units having a minimum foreign exchange earning of Rs 10 lakh. The scheme is likely to provide a major boost to export of services like healthcare, entertainment, professional services and tourism.

ix. Small-scale industries (SSI) reservations have been withdrawn from a large number of items so that large-scale producers can produce these items cheaply and export them.

Case for Export Orientation of India’s Development Strategy:

The export orientation of trade policy (or outward-looking growth strategy) is believed to have many advantages and is regarded as superior to import-substitution policy. Some of these advantages are explained here.

First, it has been pointed out that export-oriented trade policy is conducive to more efficient use and allocation of resources. Jagdish Bhagwati has emphasized the efficiency gain of export promoting trade strategy. He is of view that export orientation and import liberlisation trade strategy will ensure domestic resource allocation closer to efficient production of goods in accordance with comparative cost of a country. According to him, such a trade strategy will not lead to rent-seeking unproductive activities.

An important advantage of export-oriented strategy arises from economies of scale which can be reaped more effectively. As a result, cost per unit of output rises which will tend to lower prices of exports. Lower export prices will help in significant expansion in exports and enable us to earn more foreign exchange. As export demand or market size for a good expands this will lead to economies of scale. With adequate size of market even small-scale and medium enterprises can set up plants of optimum size to enjoy the economies of scale.

Export-oriented trade policy makes substantial contribution to economic growth by relaxing the foreign exchange constraints. Export-promoting trade policy places emphasis on industries geared towards earning foreign exchange. This helps to keep the balance of payments in equilibrium. It has been found that import-substitution trade strategy generally causes shortage of foreign exchange and leads to the balance of payments problem, as happened in case of India in 1991. Shortage of foreign exchange and balance of payments problem lowers the rate of economic growth.

On the other hand, export-oriented trade policy does not have to face the problem of shortage of foreign exchange and is therefore conducive to higher rate of economic growth. Further, a significant merit of export-oriented trade policy is that it will help to achieve self-reliance, that is, self-sustained growth of the Indian economy. As a matter of fact, import-substitution strategy was adopted in India with the belief that through it we will achieve self-reliance.

But the policy underestimated the import intensity of import-substitution process. Import-substitution strategy substantially increased our import requirements for equipment and raw materials. This necessitated a large amount of foreign exchange which could not be earned sufficiently through exports. Thus, far from helping to do away with foreign assistance, import-substitution, strategy increased our dependence on foreign capital inflows.

Export-oriented trade policy coupled with liberalised foreign investment will enable us to earn adequate foreign exchange to solve our balance of payments problem and ensure self-sustained economic growth. Above all, several studies have found a highly positive relation between growth of national income and expansion in export. However, as Balassa has pointed out that for relation between export orientation and economic growth initial conditions matter a lot.

These initial conditions include resource endowment, expansion opportunities of trade, stock of technical knowledge. No doubt, these initial conditions are important for determining economic growth. However, trade policy is certainly important for providing incentives for expansion of exports for availing of the opportunities thrown up by international trade. This will lead to the optimum use and allocation of material resources which will stimulate economic growth.