Rakshit Mohan

Rakshit Mohan

Research Associate | VIF

Aditya Menon

India’s Hamletian Dilemma About RCEP

India’s Hamletian Dilemma About RCEP

The Regional Comprehensive Economic Partnership (RCEP) is a mega trade deal, which is currently being negotiated among the sixteen growing economies of the Indo-Pacific. The deal is being negotiated between ASEAN, Australia, New Zealand, China, India, Japan, and South Korea. RCEP countries together comprise two-fifths of the global GDP and nearly one-third of the global flow of trade in goods and services. The driver behind liberalisation of tariffs and reduction of trade barriers under a free trade agreement stems from the resultant boost in absolute gains from trade. This is due to the realization of trade efficiencies which is driven by an increase in producer surplus and consumer surplus in the regional free trade area. However, the aforementioned picture may vary when viewed at the level of an individual country. India’s Hamletian Dilemma about entering into RCEP lies precisely there.

RCEP has the potential to create a divergence in the producer and consumer surplus in India, with the former being in the downward direction. Under the envisaged RCEP regime of free trade, India will have to lower tariffs on a range of products. Lowering of tariffs leads to a fall in the domestic price of a given commodity, which increases competition for domestic firms. Domestic firms already grappling with an unfavourable business environment, when faced with competitive foreign firms operating in business-friendly regimes, could potentially lose market share due to increasing import volumes of domestically produced like commodities. Thus, while gradual elimination in import duties leading to rising competition from imports would drive down prices and increase the consumer surplus of domestic consumers, it eats into the producer surplus of the domestic firms. The fall in producer surplus would further reduce the competitiveness of domestic firms and eventually push them out of business. The aforementioned argument is contingent upon the fact that Indian firms are unable to compete on a level playing field due to the existence of domestic structural constraints that hamper their performance.

Indian firms are rendered less competitive than foreign firms due to the following structural reasons. First, India, despite making significant improvements in the Ease of Doing Business (EoDB) index, lags behind all the RCEP countries other than the Philippines, Cambodia, Lao PDR, and Myanmar. India’s lag in the EoDB scores means that establishing businesses in 11 of 16 RCEP countries is easier than setting up a business in India. India, Indonesia, Vietnam and Brunei fall in the category of countries where the EoDB is ‘easy’. Eight RCEP countries namely China, South Korea, Japan, New Zealand, Australia, Malaysia, and Thailand have been categorised as ‘very easy’ for EoDB.

Second, the higher cost of accessing financial capital for Indian players vis-a-vis their RCEP counterparts due to high-interest rates in inter-bank transactions reduces the competitiveness of Indian industries when they borrow at such rates of interest. Inter-bank lending is a globally followed standard financial practice. It enables banks facing a liquidity crunch to cope with the cash outflow by taking recourse in the form of short-term loans from other banks. This rate at which banks lend to the other banks is benchmarked globally. The LIBOR is a globally accepted benchmark interest rate indicating borrowing costs among banks. Certain regions and countries have their versions of the LIBOR with minor variations. The LIBOR rate or LIBOR’s country/region-specific variant impacts cost of accessing capital for firms. Banks lend at an interest rate which is a function of the benchmarked interest rate plus a premium. The premium is set based on the risk profile of the beneficiary. Thus, the interest rate charged to customers is heavily dependent on the benchmarked inter-banking interest rate. The MIBOR rate, which serves as the Indian benchmark, was, 5.45 per cent as of 9th September. The SHIBOR, which serves as the benchmark rate in China firms was 2.6 per cent. The disparity between the rates of borrowing imposes a high cost for accessing funds on Indian businesses. Thus, the competitiveness of Indian firms is impacted in this regard compared to the other big brother in the RCEP.

Notwithstanding the aforementioned hurdles, Indian businesses face challenges at the level of the structure itself. India needs hard-hitting reforms in its factor markets. The current regime for land and labour laws renders domestic industries non-competitive for managing the cost of production. The marginal cost of production, therefore, increases leading to a fall in producer surplus of the domestic firms. Therefore, domestic firms need the cushion of duties on imports to keep their products competitive in the market.

India’s trade deficit with its partner widened in most cases where it signed an FTA. For instance, India’s trade deficit with ASEAN increased from $4.98 billion to $14.64 billion between 2010-2011 and 2015-2016 when it struck an FTA in 2010. In the year 2018-2019, India posted a trade deficit with 11 members of RCEP, which must be pondered over with caution before signing a deal as comprehensive as RCEP. Similarly, in the case of FTAs with Japan and South Korea, trade deficit burgeoned following the signing of the FTA. The trend of rising deficits with trade partners in the aftermath of FTAs must make India’s negotiators realise that factors like EoDB and lack of factor market reforms dent India’s ability to benefit from these agreements. Furthermore, RCEP will also impact the agricultural and dairy products sector due to the inflow of cheaper products from organised markets in Australia and New Zealand.

India, on account of its lower competitiveness, is a price taker in various sectors which are under negotiation in RCEP. Since India is a price taker in these sectors, it may not be able to benefit from liberalisation of tariffs. Price taking domestic firms that are non-competitive will be driven out of the market, leading to a shrink in the capacity to manufacture domestically. Shrinking of domestic industries has a spillover effect on the creation of jobs in the economy, which may also have political fallout for the government. Although the loss of jobs can be offset through Foreign Direct Investment (FDI) in the labour-intensive manufacturing sector, India would need to work on factor market reforms like labour reforms to assuage the sentiments of foreign and domestic investors.

On the matter of liberalisation of service norms and free movement of labour, India has not received significant concessions from other RCEP nations. The services industry is India’s strength but given the political implications in the host country of movement of people, RCEP nations are likely to be unrelenting on granting India concessions on services. However, even if there is a concerted effort to open up the services sector, Indian policymakers need to ask themselves a very difficult question—Is it prudent to boost up the service sector at the cost of the domestic manufacturing sector? To provide incentives to the service sector, India must not subject its manufacturing industries to external shocks until India works on internal factor market reforms diligently.

Furthermore, the time is ripe to push for concessions in the services sector because RCEP countries are faced with a demographic decline and an ageing population while the demographic trends in India remain robust. The growing population of the youth will prove to be valuable human capital both within the domestic territory of India and in nations faced with a demographic decline.

Despite the risks highlighted above, RCEP has a few silver linings for India. First, RCEP will allow India to integrate into the global supply and value chain of essential agricultural and manufacturing products, which will be beneficial for the manufacturing and processing industries in India. However, mere integration into the supply chain is not going to be productive as long as intermediate industries are not made competitive through the easing of regulations and labour market reforms. Second, the reduction of tariffs will not only make finished products cheaper but also reduce the price of intermediate goods. A reduction in the price of the intermediate goods will help make those products more competitive which have a forward linkage to the imported intermediate goods. Third, competition between firms, in the absence of structural constraints mentioned above, will increase the production efficiency of Indian firms and drive down the marginal cost of production. Finally, the inflow of foreign direct investments through multinational companies setting up manufacturing facilities in India will lead to the creation of jobs in the economy and encourage sectors to innovate and become competitive in the market. The long-run impact of the four factors mentioned above will be positive from an Indian perspective and must be considered even though the short-term prospects of RCEP presents a scenario of comparative disadvantage.

Given the complex matrix of relative gain and loss, one may ask what India can give in return if New Delhi pushes for concessions in services. Vying for autarky will serve New Delhi no purpose. On that count, it must be understood that the authors do not wish to advocate a protectionist regime guarding the manufacturing sector. Concessions need to be given in a host of sectors in which India may be able to withstand competitive pressure from foreign goods. However, critical industries with vital forward and backward linkages need to be guarded in the absence of factor market reforms. New Delhi must negotiate strongly to ensure that its core interests in the manufacturing sector remain unhampered with tariff liberalisation.

At the current stage of RCEP negotiations, given the lack of factor market reforms in India and inadequate performance in the EoDB with respect to RCEP countries, the risks of joining RCEP softly outweigh the prospects of joining the same. In the short-term, New Delhi must push hard on having a dual-tariff structure wherein vulnerable industries are subjected to different tariff rates as compared to non-vulnerable ones. The imposition of quota-based tariffs on the volume of goods imported may also be considered.

India must push the countries to reduce non-tariff barriers like unjust Sanitary and Phytosanitary (SPS) standards, Technical Barriers to Trade (TBT) and unreasonable quality regulations concerning packaging, standardisation and product specifications inter alia. Furthermore, India must push hard on demanding inclusion of concessions on services. Finally, all the provisions of the agreement, including the tariff schedule, must be open for negotiations to have room for manoeuvrability in case of a rainy day in international trade. In the long term, New Delhi would do well to ease regulations and execute land and labour market reforms. India’s Hamletian dilemma will remain unresolved until that time.

Original article was published in Strategic News International