A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 5 - External Sector

Trade Reforms, Institutional Arrangements and India’s
Position in the World Trade Organisation

Trade Reforms

Trade reforms formed an integral part of the overall structural reform process. An open trade regime has been viewed as the least vulnerable form of globalisation with enormous opportunities for higher growth emanating from higher exports and higher welfare resulting from the possibility to make available better quality products at globally competitive prices under competition from liberalised imports (Krueger, 1998). This has been the rationale and the guiding principle for the trade reforms in India. As has been brought out by a number of individual and cross-country studies, trade restrictions reduce real economic growth by distorting the pattern of resource allocation, and by discouraging innovation and technical progress. Import substitution inflicts static costs on the economy by way of resource misallocation as also dynamic costs by raising the incremental capital-output ratios and exclusion from new technology. While the traditional argument for free trade in terms of allocative efficiency is made under the assumption of perfect competition, it is also argued that in imperfectly competitive markets, increased competition through trade would bring about welfare gains by reducing the dead-weight losses engendered by domestic monopolies and oligopolies (Helpman and Krugman, 1989). Beneficial impact of trade liberalisation on economic growth is also envisaged through the international production networks which spread the sequential production processes across national boundaries. Some of the channels through which trade liberalisation would affect the welfare of the people are: the access to imported goods, relative prices of tradable goods, relative wages of skilled and unskilled labour, impact on government revenue, incentives for investment and innovation affecting economic growth, and the vulnerability of the economy to external shocks (Bannister and Thugge, 2001). In the debate on the sequencing of different channels of globalisation, the general view has favoured sequencing driven by trade liberalisation (Edwards and van Wijnbergen, 1986; Rodrik, 1987; Mussa, 1984). Cross-country experience on trade liberalisation is discussed hereunder.

Trade Liberalisation: Cross-Country Experience

The rationale for trade reforms is essentially based on the drawbacks of trade intervention, as well as superior growth performance of countries that adopted liberal outward-oriented policies. The inward-looking trade policies adopted by the developing countries till the 1980s were rooted in the argument that trade policies should not be conditioned by prevailing world relative prices, given the low income and price elasticities of primary commodities which could lead to a secular deterioration in the terms of trade. The arbitrary nature of quantitative restrictions that characterises trade interventions creates uncertainty for domestic producers and consumers. These distortions are manifested in efficiency losses in domestic production, weak competition in the domestic market, and emergence of rent seeking behaviour and corruption. The removal of quantitative restrictions or their conversion into tariffs, as part of trade reform package, has several advantages such as reduction in scope for rent-seeking, transfer of rents from the importers to the government, and greater transparency and predictability of the trade regime. Moreover, due to the measurability of tariff reductions, the designing and monitoring of trade reform has become easier. Endogenous growth literature (Sala-i-Martin, 1990; Baldwin and Francois, 1999) suggests that beneficial impact of trade reforms on economic growth could arise through technology transmission, international integration of production, reduction of price distortions and enhanced efficiency.

Till the early 1980s, the pattern of trade policy across countries broadly reflected the extreme preferences of national policy makers for export-pessimism-cum-import substitution on the one hand and export-led growth on the other. In tandem with global developments, export-promotion and greater trade integration became the policy objective of almost every country by the 1990s, although the extent of trade integration varied considerably across countries. Even so, some general features of trade liberalisation include tariff reductions, quota elimination, relaxation of import licensing, conversion of quotas into tariff, compression of the range of tariffs and rationalisation of collection arrangements (Greenaway, 1998). Dismantling of tariff and non-tariff barriers under the multilateral trading arrangements also exposed many inward-looking economies to external competition. Since developing countries depend to a large extent on trade tax revenues, one of the important concerns regarding trade liberalisation was its revenue implications. It has generally been observed that the revenue implications of trade liberalisation are uncertain and depend upon the country’s initial conditions and the components of the reform package which should be kept in view while formulating the trade liberalisation strategy (Blejer and Cheasty, 1990; Tanzi, 1989; Greenaway and Milner, 1991; IMF, 1998). As far as the sequencing of reforms is concerned, domestic factor (labour) markets need to be liberalised before commodity markets so as to facilitate production decisions. Trade liberalisation also needs to precede capital account liberalisation in order to preclude further distortions in domestic production consequent upon capital inflows to those sectors.

Loser and Guerguil (1999) have documented the impact of a sharp reversal in trade policy of the Latin American and Caribbean (LAC), countries particularly in the1990s, from import substitution to trade liberalisation. Trade reform mainly comprised:

1. a significant reduction in both average tariff (from 45 per cent in 1986 to 14 per cent in 1998) and maximum tariff (from 80 per cent to about 30 per cent);

2. removal of most of the quantitative and other non-tariff barriers which consequently affected only 11 per cent of total imports in 1997 as against almost 40 per cent in the mid-1980s; and (iii) liberalisation of currency markets and elimination/ reduction of foreign exchange controls on international payments.

A comparison of the trends in the trade restrictiveness index, the real effective exchange rate and import and export ratios for a number of LAC countries shows that:

1. trade liberalisation was both significant and rapid;

2. trade policy reform coincided with currency appreciation in almost all countries;

3. the import ratio increased significantly (an average of 5 percentage points) in all the countries and within a short time span (2-3 years), perhaps responding to currency appreciation. There was a shift in the composition of imports from primary products to manufactures;

4. the response of the export ratio was relatively small and delayed (an average increase of 4 percentage points after a lag of 6 years), indicating that the positive impact of trade liberalisation was partially dampened by currency appreciation; and

5. remaining market restrictions including those in respect of the labour market, competition and financial markets tended to increase costs and circumscribe productivity gains, limiting thereby the positive impact of trade liberalisation.

The high growth rate of the East Asian economies, including Hong Kong, Indonesia, Malaysia, Korea, Singapore and Thailand (at least till the financial crisis of 1997) was, to a large extent, based upon their export performance. All these countries adopted strategic export policies that set up a free trade regime and offered a gamut of incentives for exports. Furthermore, general import restrictions were not imposed even in the face of current account deficits. In general, trade liberalisation was part of a policy package that comprised devaluation, exchange rate unification, fiscal reforms and foreign aid or concessional loans to neutralise the impact of a temporary current account deficit. The export strategy adopted by these economies included at least one of the following four elements, viz., access to imports at international prices (via free trade/export processing zones, tariff exemptions, duty drawbacks); export financing (often at subsidised rates); market penetration (via direct income tax incentives, exporter associations, setting up of international trading companies); and flexibility. An IMF study (1999) on the experience of six countries, viz., Argentina, Philippines, Poland, Morocco, Malawi and Senegal which undertook trade liberalisation over the mid-1980s to mid-1990s shows that phasing out of quantitative restrictions received priority in all cases, although the pace and nature of the reform was guided by revenue concerns. Poland in 1990 placed strong emphasis on eliminating quantitative restrictions which was an integral element of its ‘big bang’ transformation. The 1991 trade reform programme in Argentina included tariffication of certain import quotas and the elimination of some reference prices. Malawi’s trade liberalisation programme in the late 1980s included a focus on eliminating foreign exchange rationing. Similarly, Senegal embarked in 1986 on a phased reduction of quantitative restrictions. The Philippines concentrated on the tariffication of quantitative restrictions during the initial phase of its trade liberalisation efforts. Morocco’s reforms adopted in 1983 included a gradual elimination of quantitative restrictions on imports and the abolition of import deposit requirements.

All countries in the sample also stressed tariff reductions in their reform programmes, though to varying degrees. Senegal’s liberalisation efforts in the mid-1980s were hampered by weak macroeconomic management and stagnant trade. As a result, tariff reductions were accompanied by serious revenue shortfalls which led to a reversal of the tariff cuts. The second phase implemented in conjunction with the 1994 devaluation was successful. In the Philippines, reduced reliance on trade taxes has at times been constrained by the weakness of domestic tax mobilisation. Along with tariffication of quotas, a temporary import surcharge was imposed in the early 1990s. As a result, the collected tariff rate declined only slightly from 16.7 per cent in 1985 to 14.4 per cent in 1995. Several countries gave high priority to reducing tariff dispersion and consolidating tariff structures. Some countries also demonstrated how domestic taxes can reinforce the protection provided by trade taxes and also highlighted the importance of broadening the domestic tax base as part of an overall liberalisation package.

A study by OECD (2001) on the trade reforms undertaken by transition economies (the Central Eastern and European Countries (CEECs) and the countries belonging to the Commonwealth of Independent States (CIS)) since the beginning of the 1990s, observes that:

1. the uneven progress and diverse outcomes of the reforms in individual transition countries resulted from a complex interaction of initial economic and political conditions prevailing in individual countries and the choice of their reform strategies;

2. regional integration and multilateral disciplines played a critical role in this process by providing legal and regulatory guidance for designing new trade policies and by imposing trade policy commitments thereby stabilising trade liberalisation achievements and reducing the risk of protectionist reversals;

3. recent developments in transition economies show a clear relation between GDP performance and trade openness. In general, between 1990 and 1999, most CEECs saw their GDP and exports per capita increase simultaneously. Few exceptions to this general trend can be explained by special situations of individual countries, recently affected by regional conflicts (Bulgaria) or by the financial and economic crisis in Russia in 1998 (Latvia, Lithuania). By contrast, all CIS counties were confronted with the parallel contraction of per capita GDP and exports;

4. at the beginning of the transition process, many CEECs recorded a trade surplus, due to drastically devalued exchange rates. Later, exchange rate appreciation and a revival of domestic demand fuelled import growth, while exports started to lag behind, partly because of the contraction of external demand, but mostly due to delays in restructuring. As a result of these cumulative effects, most transition economies faced serious deterioration of their trade balance. Measured as the percentage share of GDP, current account deficits reached critical levels in several transition countries, both among the CEECs (11 per cent of GDP in Lithuania in 1999) and the CIS (46 per cent of Turkmenistan’s GDP in 1999). In this regard, Russia, as a major commodity exporter, has been an exception.

In the post-war period, several developing countries pursued import substitution-led development strategies. Poor growth resulting from such strategies, however, led to policy reorientation in the early 1960s. While one set of countries started giving more incentives for the export sector even while persisting with a moderate form of import substitution (for instance, Brazil, Argentina and Mexico), another set of countries made a more fundamental shift in favour of outward orientation (for instance Korea, Singapore and Taiwan) (Balassa, 1989). The Indian development strategy recognised the significance of liberal trade policy in the early 1980s, which was manifested in the form of a number of important recommendations made at that time by several Committees. The notable ones focused on a shift in emphasis from control to deregulation through simplification in import licensing system (Alexander Committee, 1978), clear recognition of dynamic comparative advantages associated with export growth (Tandon Committee, 1980), the need to harmonise foreign trade policies with other macroeconomic policies, advantages of an export-led growth strategy, a phased reduction in effective protection (Abid Hussain Committee, 1984) and the need to discourage inefficient import substitution (Narasimham Committee, 1985). Notwithstanding these concerns, the trade regime continued to be characterised by a licensing system which together with a high tariff structure protected the economy from external competition. In addition, the trade performance was constrained by restrictive foreign investment policies (RBI, 1999).

The process of trade liberalisation, however, gathered momentum only during the 1990s in the aftermath of the external payments crisis. The policy measures undertaken aimed at making domestic industry cost-efficient by enhancing efficiency in resource use under international competition, which was expected to derive a better export performance in the long-run. The major trade policy changes in the post-1991 period included simplification of procedures, removal of quantitative restrictions, and substantial reduction in the tariff rates as also their dispersion as recommended by the Tax Reforms Committee, 1992 (Chairman: Raja J. Chelliah). Furthermore, the reach of the export incentives was broadened, extending the benefits of various export-promotion schemes to a large number of non-traditional and non-manufactured exports. Following the announcements in the Export Import (EXIM) policies, various changes were effected such as the removal of quantitative restrictions, strengthening the export production base, removal of procedural bottlenecks, technological upgradation and improvement of product quality. Various steps were also taken to promote exports through multilateral and bilateral initiatives, including identification of thrust areas and focus regions. The policy stance also marked a move away from the provision of direct export subsidy to indirect promotional measures. India also took several policy initiatives at the multilateral levels for tariffication of the non-tariff barriers. As per India’s commitment to the World Trade Organisation (WTO), India agreed to the phased removal of all balance-of-payments (BoP) related quantitative restrictions by end-March 2001.

The tariff rates have undergone considerable rationalisation during the 1990s. Prior to the 1990s, the maximum import duty rates on certain items were over 300 per cent. The peak rate of import duty on non-agricultural imports was gradually reduced from as high as 150 per cent in 1991-92 to 25 per cent (excluding agriculture and dairy products) by 2003-04 The weighted average import duties on various goods, even though reduced from the high levels prevailing earlier, are still higher than that of some of the East Asian countries. The rate for China is expected to be phased down to less than 10 per cent in the coming years as part of China’s agreement in connection with its WTO entry (Government of India, 2001).

The weighted average tariff rates of India for various broad import groups are set out in. It is observed that although the average tariff rate declined steadily from 1991-92 to 1996-97, thereafter, it edged up again, inter alia, due to the imposition of various surcharges. The increase in the weighted average tariff rates since 1998-99 has been predominantly in agriculture and consumer goods sectors.

The Government, however, is committed to reducing tariffs to levels comparable with those prevailing in East Asian economies. The Finance Minister in the Union Budget for 2001-02, had stated that there would be a progressive move within three years to reduce the number of rates to the minimum with a peak rate of 20 per cent. This was reiterated in the Union Budget for 2002-03, wherein it was stated that by 2004-05, there would be only two basic rates of customs duties, namely 10 per cent covering raw materials, intermediates and components and 20 per cent covering final products. Keeping in line with these announcements, the Union Budget for 2003-04 while reducing the customs duties on several products, brought down the peak tariff rate to 25 per cent (excluding agriculture and dairy products).