Why India is wise not to join RCEP

On November 15th, the Regional Comprehensive Economic Partnership (RCEP) was signed, an Asian-Pacific free-trade agreement that will probably become effective sometime in mid-2021. The agreement has been signed by 15 countries: all 10 ASEAN[1] countries, Australia, China, Japan, South Korea, and New Zealand. Covering roughly 30% of global population and GDP, it is easily the largest FTA in the world.

India is not participating

India was a member of the RCEP drafting committee from its inception in 2011, but in November 2019, it decided to opt out, claiming that some of its main concerns were not being addressed. This is generally considered to be both an economic and geopolitical loss for India (see for example here, here, and here). Bloomberg even wrote an open letter to Prime Minister Modi about it. Many analysts believe that India’s decision not to join RCEP will give China complete control over the biggest trading blocks in the world and India will be isolating itself. A report by the Peterson Institute on International Trade supports the view that non-participation is a policy mistake, showing that by not joining the RCEP, India could be looking at a GDP loss of INR 450 billion, compared to a gain of INR 4,450 billion if it were an RCEP participant. However, in this op-ed we argue that India’s choice not to sign the RCEP is actually quite rational.

[1] Association of Southeast Asian Nations (ASEAN): Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam.

To address the benefits of free trade, economists often point to the work of the British economist David Ricardo. His principle of comparative advantages dates to 1817. It is as elegant as it is simple: every country can benefit from free trade, even countries that do not have an absolute cost advantage in one single traded item. Ricardo showed that total consumption and production in countries that trade which each other increases, if these countries specialize in the goods they are relatively the best at. For instance, if another country can make iPhones at lower opportunity costs than yours can, your country would do well to import those iPhones and spend its time and resources on manufacturing something else more productively.

Reality is not that simple

Ricardo’s ideas only work in a world where capital is immobile, the geopolitical environment is benign, and there is an instantaneous frictionless specialization towards comparative advantages. But reality is not that simple. According to Dani Rodrik, economists advocating free trade are often reluctant to mention the flip sides of free trade, which goes at the expense of their credibility with the public. The fact is, international trade is a complex system characterized by market failures, where the international level playing field for firms is affected by transaction costs, economies of scale, and government policies. Consequently, the economic outcome of trade is not always beneficial for individual countries. Unlike other Asian countries, trade liberalization in India since the 1990s has only resulted in minimal employment gains. Moreover, trade also generates redistribution effects and creates winners and losers. An impact analysis of the ASEAN-India free trade agreement (AIFTA) concludes that it will create opportunities for Indian firms active in machinery, chemicals, and transport equipment, but at the same time will result in losses for Indian SMEs in food & agri and the light manufacturing sector.

Ultimately, we are not against free trade per se and have reported positive findings of trade and foreign direct investment as important conduits for international knowledge spillovers (here and here). But the virtues of trade should always be examined within the context of individual circumstances and places, which brings us back to the case of the RCEP and India.

To examine the potential implications of the RCEP for India, we first take a look at the trade dependencies between RCEP members and India (see Table 1). Table 1 shows the relative bilateral trade position of the larger RCEP members with each other, as well as India, the EU, and the US. Each column should be read from top to bottom, where green represents a trade surplus as a percentage of GDP and red represents a deficit. For instance, Australia had a trade surplus with China in 2019 of 3.7% of GDP, whereas it had a deficit of -0.6% with Thailand.[2]

As the table makes clear: most of the larger RCEP economies are net exporting nations, except for the Philippines and New Zealand (see bottom row Total in Table 1). Moreover, the RCEP members do not have particularly large trade deficits with each other, with a few exceptions (e.g. Australia « China, China « South Korea, Vietnam « South Korea). This implies that most RCEP members are exporting beyond RCEP borders. Indeed, RCEP members show much more green than red compared to the US. The same is true in relation to the EU, albeit to a somewhat lesser extent.

[2] Trade figures show some anomalies as well. For instance, China and Japan both run a trade deficit with each other. By definition this is impossible and might be attributable to differences in statistical definitions.

In short, RCEP is a trade bloc of net exporters focused more externally than internally. The only way for it to become something different would be if one of its larger members decided to become a major net importer, sucking up the goods from others. Is that realistic? Arguably not, as long as China is openly talking about 'dual circulation' to promote domestic production for its domestic market, remains wedded to a political-economy model that generates more supply than demand and matching huge trade surpluses.

If China is not going to be the buyer of last resort, which large RCEP member is? From this perspective, it is easy to see why the current members have left the door open for India to still join, and even included some chapters safeguarding India’s interests in the final version of the treaty. India signing the agreement would substantially decrease its relatively high tariffs (Figure 1) and enable other RCEP members to gain easier access to its large market of 1.4 billion consumers.

But that is exactly why India is reluctant to join the RCEP. Over the last five years, RCEP members were on average responsible for almost 70% of India’s trade deficit (Figure 2). This trade deficit has weakened India’s external position (Figure 3), which affects India’s financial conditions and creditworthiness, while also limiting its options to adopt unconventional monetary policies (see here).

True, if it joined the RCEP, India would also have access to a new playing field. Participating would offer Indian firms new markets and technologies and new sources of foreign capital to drive economic transformation. This is the line of reasoning Bloomberg has presented.

Yet, it would also introduce enormous amounts of additional foreign competition – and the RCEP playing field is not exactly level. For example, lower tariffs within the RCEP is a step towards a Ricardian optimal outcome, but again, reality is more complex. Trade barriers are not just about tariff rates. Non-tariff barriers (NTBs) to trade, ranging from administrative burdens to outright quantitative restrictions, have become increasingly important. Furthermore, OECD data on NTBs indicates that India is hardly the most protectionist country, being outflanked by RCEP members Australia, Japan, and China (Figure 4). Importantly, the RCEP has not made any arrangements on lowering NTBs.

How can Indian firms compete with Chinese state-owned enterprises that have access to all kinds of official and unofficial support and all that excess capacity to boot? One possible outcome of India joining the RCEP could be a failure to industrialize in the face of a surge in imports, which would leave its economy dominated by agriculture and services. That kind of Ricardian comparative advantage would mean a larger number of lower-wage jobs, which would bring a halt the economic aspirations of campaigns like "Make in India" and "Atmanirbhar Bharat" intended to boost local manufacturing.

Comparing the comparative

For proof that this process of Ricardian comparative advantage can be either an advantage or a disadvantage, one simply needs to look at the relative trade balance of India vis-à-vis China in recent years by SITC category (see Figure 5). As can be seen, the deeper that trade relation grew, the more we have seen a shift towards imports of high-skill and technology-intensive manufactures from China, while India’s exports consist of a stable chunk of commodities. The socio-economic and political implications should be obvious.

On a related front – quite literally considering ongoing border tensions – without its own strong industrial and technological base, India will always be in an increasingly inferior geostrategic and military position vis-à-vis China, or could end up becoming reliant on it for key inputs or products that might be withheld when needed. The critics of Ricardo are, very regrettably, right to note that not all goods are equal in all circumstances, and most certainly not in an increasingly volatile regional geopolitical environment.

While we acknowledge that there are valid reasons for India not to join the RCEP, we do not recommend that India continues to follow the route of full-blown protectionism either. When India resorted to protectionism in the past it did not yield promising results for the economy. The manufacturing industry produced new steam locomotives until the early 1970s, after most developed economies had already stopped operating them and 10 years after Japan had begun making high-speed Shinkansen trains.

The so-called infant industry argument – that teaches countries can build up their industrial capacity behind high tariff-walls, only to open up after the industry is strong enough to face foreign competition – apparently did not work for India and has been disputed over the course of time (see e.g. here and here). Srinivasan and Tendulkar (2003) argue that Indian firms shielded by protectionism could “sell practically anything that they produced in the domestic market and thus had little incentive to improve their international competitiveness.”

What we do advocate is that India should buy itself some time to fix domestic problems before further opening up to trade. India’s domestic challenges are substantial: it needs to reform the low-productive agricultural sector, strengthen the (public) banking sector, reduce labor market rigidity and foster labor market mobility, broaden the tax base, improve the education and innovation system, reform land acquisition laws, reduce bureaucracy and red tape, and push back on pollution, and so on and so forth. Improving these factors might well be a bit easier without aggressive net exporters breathing down your neck.

Also published on Bloomberg/Quint, December 28, 2020