Trump’s tariff shock and why India must act now

Now is not the time to teach basic international macroeconomics to the President of the United States of America. Renowned economist Jeffrey Sachs expressed this well in a public speech when he said that high trade deficits, which are bothering President Donald Trump, are not because of trade policies like low tariffs. It simply means that Americans like to buy beyond their productive or earning capacity — much like going on a binge with a credit card.

America’s production, earning, investing, saving and buying activity is captured by a basic equation (called an ‘identity’ in economics textbooks), per which the trade deficit is equal to the savings–investment imbalance. In other words, the excess of imports over export earnings mirrors the excess of investment over domestic savings.

This basic equation identity is unaltered by any changes in import tariff rates, any sanctions imposed on Russia or China or any military spending or aid given to Israel or Ukraine. It reflects consumer behaviour and investor preferences. It is not an expression of business sentiment such as that expressed by the stock market. It is worth noting that America’s stock market remains at historic highs, despite the tariff mayhem unleashed by President Trump.

The above equation identity means that any dollar shortfall needed to pay for the trade deficit is supplied by foreign investment inflows, which is the savings–investment imbalance.

But that inflow comes at a cost. If it is as debt capital inflow, it increases the indebtedness of the country. No wonder the aggregate debt of the US sovereign alone is $37 trillion, representing 125 per cent of its GDP. The cost of this debt — the long-term interest rate — is close to 5 per cent, even though inflation is quite low. The difficulty of continuing to attract foreign inflow of capital means interest rates will remain stubbornly high.

The other variable that can affect the trade deficit is the dollar exchange rate. Since no other currency in the world is seriously considering strengthening its own currency, the dollar will remain strong keeping the trade deficit high.

The bottom line is that harsh tariff policies against trading partners of the US will not drastically reduce the size of the deficit but will hurt domestic imports because of higher cost, and will hurt exporters from foreign countries, as their net earnings and net export volumes may go down. Production, volume of imports and exports (to some extent) and incomes will go down, hurting GDP in the medium term.

The tariffs are not a tax on foreigners but are paid by importer companies in the US, who pass along the cost to their customers via higher prices. Exporters may face lower profits or volumes, but one estimate is that exporters bear only one-fifth of the rising costs from tariffs while Americans will bear most of the brunt. But President Trump’s policies change so frequently it is impossible to make a firm prediction based only on current policy action.

Despite showing early willingness to negotiate a mutually beneficial trade deal, and despite cultivating friendship and goodwill with President Trump and his team, the outcome has been quite bad for India. The tariff of 50 per cent on Indian exports (basis Trump’s latest threat, at the time of going to press) makes India’s position worse vis-à-vis peers like Vietnam, Indonesia or Mexico.

It will hit the exports of sectors such as textiles and garments, gems and jewellery, leather, footwear, chemicals and electrical and mechanical machinery. Some reports suggest that sectors like pharma, semiconductors and energy products are exempt. (We couldn’t find a definitive confirmation of the exempt list on any official US government source — Ed).

India reportedly drew the line on three things. First, no open access to agriculture and the dairy market in the country, especially for corn, soyabean and dairy produced from cattle fed with animal protein. Second, no access for genetically modified crops or agriculture products. Third, no import of ethanol for fuel.

An additional fourth point that is proving to be sticky is India’s continued insistence on its freedom to import crude oil from Russia. This seems to have irritated Trump the most, since he sees it as a direct affront to sanctions against Russia.

India must carefully weigh its options, given that Trump’s strategy always puts the other side in reactive mode. Most trading partners end up either giving too much for too little (like UK, EU or Indonesia) or use leverage to counterstrike (like China with the rare earths export ban). India was tilting towards giving in too much, given the critical importance of the US market — the fact that it is the only large economy with which India enjoys a substantial trade surplus.

This mini crisis must be used to accelerate progress on economic, administrative and other reforms. There is certainly no 1991-like crisis when India had to beg for short-term foreign credit to shore up its forex reserves — the Indian economy today has size and resilience.

But let us not lose sight of the worrying economic signs. Near zero net foreign direct investment, stagnant private sector investment spending, 30 per cent unemployment, low productivity (half the world average) across agricultural crops, water stress as water tables sink deeper and free electricity keeps pumps working overtime, the increasing burden of doles to beneficiaries, the large mismatch between skills demanded (in this age of AI and automation) and output of educational institutions, and, most importantly, the continued shackling of the farmer, at the mercy of procurement policies, fickle bans, prohibition on forward trading and rigid land markets.

The farm laws need a consensus and consultative approach. The labour laws passed in Parliament need to be applied and implemented via the four codes in all states.

It is time to use this Trump tariff shock as an opportunity to push forward on all these reforms, to make the economy chug faster while also making it more inclusive.

Views are personal

Ajit Ranade is a noted economist. More of his writing can be found here

Article courtesy: The Billion Press