India’s trade caught in the middle

Why in the News

India-U.S. trade talks have reached a “plateau”, with further concessions from either side difficult, the Finance Minister has said. The stake is India’s trade surplus with the U.S., which offsets a structural trade deficit with China. A heavy U.S. tariff could erase that surplus and put fresh pressure on the rupee and on foreign exchange reserves.

How is the rupee’s value set, and how does the RBI manage it?

1. Exchange rate: The rupee’s price is set by the demand for and supply of dollars, like any market price. When one dollar buys more rupees, the dollar has risen and the rupee has depreciated.
2. Demand for dollars: It comes from imports and capital outflows, meaning outward Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI). A costlier dollar makes imports dearer, so demand is assumed to fall.
3. Supply of dollars: It comes from exports, capital inflows, transfers, external borrowing and deposits. It also comes from Net Factor Income from Abroad (NFIA), meaning income earned abroad minus income paid abroad.
4. Managed float: The Reserve Bank of India (RBI) keeps the rupee within a preferred range. It releases dollars when the rupee threatens to fall below that range and adds to reserves when it rises above.
5. The takeaway: Anything that cuts dollar supply or raises dollar demand forces the RBI to spend reserves to hold the rupee in its range.

Why does the surplus with the U.S. matter?

1. Two-way imbalance: India runs a trade deficit with China but a surplus with the U.S., so earnings in one market help pay for purchases from the other.
2. Structural deficit with China: India buys Chinese goods that are not easily substitutable, at least in the short run, so the deficit cannot be reversed quickly.
3. Goods-led surplus: India’s surplus with the U.S. is much larger in goods than in services. This goods balance is the main “bone of contention” for the U.S. President, and the tariff aims to reverse it.
4. Twin threat: A heavy U.S. tariff on Indian goods and the effect of artificial intelligence (AI) on exports could together reverse the surplus.
5. Right benchmark: A deal that eases the tariff somewhat is better than no deal. Its real test is how close it comes to the status quo before the tariff was imposed.

How could a tariff turn into a currency crisis?

1. Crude shock: A rising dollar price of crude imports pushes up dollar demand and threatens depreciation. The RBI has run down reserves to defend the rupee over the last two years.
2. Recent pressure: Demand for dollars outpaced supply in four of the last nine quarters, with a sharp rise after the closure of the Strait of Hormuz.
3. Tariff effect: Lower exports to the U.S. would cut the supply of dollars, and the resulting depreciation would go far beyond what India faces now.
4. Vicious cycle: Keeping the rupee within its range may need a large loss of reserves. Beyond a point, investors fearing losses pull money out faster than imports fall, so outflows and depreciation feed each other.

Challenges

1. Market concentration: The surplus rests on one market’s demand for Indian goods, so a single tariff decision can tip India’s external balance.
2. Slow import substitution: Replacing Chinese goods with domestic or other sources takes years, so the deficit persists even as the surplus shrinks.
3. Dollar-priced energy: Crude is paid for in dollars, so any supply shock raises dollar demand whatever happens in trade talks.
4. Finite reserves: Every intervention spends reserves that cannot be rebuilt quickly if exports and capital inflows weaken together.

Way Forward

1. Wider product mix: Diversify the exportable product mix so that export earnings do not hinge on a few goods sold to one buyer.
2. Regional diversification: Expand exports across regions rather than relying heavily on the U.S. market.
3. Global South markets: Build the trade and industrial policy architecture needed to recover lost U.S. sales within the Global South.
4. Gradual shift: If U.S. pressure continues, reduce dependence on the U.S. economy in steps rather than abruptly.

Conclusion

India’s external balance depends on a surplus with one partner covering a structural deficit with another, and a tariff can break that arrangement. Whether new products and markets replace lost U.S. sales before reserves run down further will decide how much pressure the rupee absorbs.

Matching Previous Year Question

“[2022] With reference to the Indian economy, consider the following statements : 1. An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee. 2. An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness. 3. An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER. Which of the above statements are correct ? (a) 1 and 2 only (b) 2 and 3 only (c) 1 and 3 only (d) 1, 2 and 3 ANSWER: (c)”