In the India-China relationship, the question of trade deficit

For more than a decade, India’s large trade deficit with China has been a growing concern. The focus of the issue, however, has largely been political. With the confrontation along the border and the pandemic leading to a campaign for self-reliance, the question of trading with a country that is also clearly a strategic adversary has gained renewed policy interest.

Final consumer goods are quite often, in public perception, (mis)understood as constituting the biggest chunk of Indian imports from China. While the absolute numbers definitely seem large, what do the facts suggest?

Based on the Broad Economic Classification categories, goods for final consumption, in 2020, accounted for 7.48% of imports from China. However, about 63% of imports were in the intermediate consumption category, which is defined as “goods and services used up in the course of production within the accounting period”. The import of capital goods comprised 16% of imports from China. As things stand, about 80% of imports from China are used in the production process.

Another finer level of analysis resorts to examining the trade in parts and components (P&C) — items such as blades, engines, electronic instruments and motors, which aggregate or supplement larger final goods such as gas turbines or mobile cranes. India’s share of imports in this category over the years has been fairly low and steady, hovering around the 10% mark.

But over the course of the last two decades, the share of P&C in imports from China rose from about 12% in 1998 to about 22% in 2020. Similarly, the share of China in India’s P&C imports rose from a paltry 5% in 2001 to about 35% in 2021. In summary, what we observe is an increased Chinese role in the Indian production process. Ironically, China itself sources a lot of inputs from the East Asian economies with which it holds deficits.

Are there any policy options to reduce this deficit? Resorting to taxing these intermediate goods heavily and/or trying to produce them domestically would be returning to the early import-substitution years (an economic disaster). Neither can one source these inputs from other countries easily — China has a proximity privilege, which, in trade empirics, is a strong determinant of bilateral trade flows. Unless transport costs are enormously reduced, it makes no economic sense to source these from other countries. And even if the government were to tax final consumer goods, it would not be adequate to correct the deficit.

With no realistic policy options in the short-run, we revert to a fundamental question — should we be concerned about the trade deficit? The answer would perhaps be in the negative given that India still is a largely unskilled labour-surplus economy with a jobs crunch (which was exacerbated during the pandemic). To solve the jobs problem, an important agenda would be ramping up domestic manufacturing.

Historically, leading export countries began as assemblers and later moved on to capturing segments of the production chain. With large assemblers growing, domestic firms see a profit opportunity to start producing intermediate inputs for the assemblers. India, however, has never employed such a strategy.

Given that a large chunk of the imports from China goes into the production process, an ideal strategy would take advantage of this deficit, accelerate domestic manufacturing via assembling and find newer destinations to market output. Coupled with massive investments in infrastructure, it can also be a step towards addressing the jobs crisis.

It is not necessary to pursue cheap exports. An enabling environment via service links (policy openness, low wages, and good infrastructure) will enable manufacturers to seek their own comparative advantage — better quality, lower prices through lower wages, niche products or anything else. Moreover, if strategic concerns are to be addressed, investments in transport infrastructure, at least in the short-run, would make it possible to source intermediate inputs from other countries.

Since Adam Smith, we have understood that gains from trade are larger than the costs. Ignoring this enormous gain made in knowledge would not be wise.