On February 7th, the U.S. and India announced a new interim trade deal between the two countries after months of extremely high tariffs imposed by the U.S. on India. Under this, U.S. tariffs on Indian exports will drop to 18% from as high as 50%. India will lower or eliminate tariffs on what it claims are some agricultural goods as well as many industrial goods.
The statements from both sides haven’t matched well. For example:
- Trump said India would stop buying Russian oil and instead buy more American and Venezuelan oil, but India has not said anything about this. Trump has also signed an Executive Order saying the U.S. will monitor Indian imports of Russian oil.
- The Indian Commerce Minister has said that the trade deal will not hurt Indian farmers and that sensitive sectors will remain protected. The U.S., however, has lauded expanded access for American agricultural exports.
Given the lack of detailed text, it is very difficult to tell what the actual deal will be. But regardless, I want to talk about trade deals in general.
Imports have to be paid for, somehow
This one isn’t a shocker, but imports are always paid for somehow. Current account deficits and trade deficits are ex-post, i.e., they measure what happened in the past. There are two ways to pay for imports:
- Current Account
- Capital/Financial Account
The current account shows what a country sells and buys from the rest of the world (goods and services), plus the money it earns or gives (wages, interest, gifts). It does not show borrowing, lending, or buying assets.
So, Current Account = Trade Account + Net Income + Net Transfers
Net income includes wages, interest, profits, and dividends the country’s residents earn minus what it gives to the rest of the world. For India, this is typically negative, since interest and dividends are paid out because of foreign investments by the rest of the world.
Net transfers include remittances, foreign aid, donations, etc., where a country gets money without giving anything in return. For example, a person in Saudi Arabia sending money to a relative in India is a remittance. Here, India isn’t going into debt to receive this payment.
And the trade account is obvious; it’s exports minus imports. Since we assume a deficit, exports can’t pay for imports.
All this is in an open economy, i.e., an economy with minimal restrictions on trade and capital flows. Trade is determined by market participants. Governments have some influence by way of tariffs, but ultimately, it’s not something they can control.
Both governments, India and the U.S., are pretending as if the trade balance is something they can control. This is not true.
So, Can India import $500 billion worth of goods from the U.S.?
The U.S. is claiming India will import $500 billion worth of goods from it. This is not something I believe is possible in a vacuum. The U.S. loves to count airplane orders as part of this deal. However, the Indian government does not buy the planes; they are bought by private entities like Air India (now privatized) and IndiGo.
Now, let’s move on to the financing part. Trade, as said before, is always financed. It’s financed by:
- Net Income (not possible for India since it’s in deficit)
- Net Transfers (mostly remittances), which is huge but is used to cover the existing trade deficit India has with China and other exporting countries
- Exports
- Net Capital Flows
None of these are under the complete control of India. India cannot decide to have more net transfers; the people sending money have to do it. Similarly, India cannot increase net capital flows unilaterally, since that depends on the mood of foreign investors.
You can further make a distinction between bilateral trade between India and the U.S. and India’s financing sources from the rest of the world. So, India’s trade surplus with the U.S. is definitionally financed by:
- Net Income (again, in deficit, so not a source) from the world
- Net Transfers
- Exports to the world other than the U.S.
- Net Capital Flows
So, to import $500 billion worth of goods, India will somehow have to export that much, something that isn’t possible because you need to export to countries other than the U.S. Unfortunately, in our world no one wants to be a net importer; everyone wants to be a net exporter, which isn’t mathematically possible.
One might say, what if Air India or whatever company went to the foreign exchange market and bought some U.S. Dollars with Indian Rupees? The answer is that there always must be a counterparty. When you give Rupees, someone must be there to give you Dollars. And under a floating exchange rate regime, that is a willing counterparty, and they set the price (hence, float).
If someone tries buying up too many U.S. Dollars beyond what the foreign exchange market liquidity allows, the Rupee will depreciate. In the process, you will get less and less U.S. Dollars for the same amount of Rupees. Balances balance. Some of the Dollars obtained from the foreign exchange market will be from exporters, some from capital flows, and some even from the RBI via market interventions (in limited amounts). However, there isn’t any magic going on; a country can’t get more than what others are willing to give it.
When the cost of the plane goes from ₹1,000 crore (for example) to ₹1,100 crore due to depreciation, it’ll become unprofitable for them, and the trade surplus (for the U.S.) never manifests.
Now, let’s move on to what a trade deficit actually is. A trade deficit means a country is getting more real goods and services from the rest of the world than it is willing to give to it. Assuming net income and net transfers are zero, this has to be financed by a capital/financial account surplus, since the identity is:
Current Account + Capital/Financial Account + Change in Reserves = 0
When India has a current account deficit, as it does in the aggregate, it means it is obtaining more real goods and services from the rest of the world. This is financed by a capital/financial account surplus. This is good for India in a real sense, and it exists because the U.S. and others are buying up financial assets (equity, debt, etc., via FII) in India, mainly denominated in Indian Rupees, India’s own currency.
Even if the Rupee is depreciating, the current account deficit means the real terms of trade are working in favour of the country.
What if India had fixed exchange rates, as it did before 1991?
A fixed exchange rate with a continuous current account deficit is dangerous. The country is getting more from the rest of the world, and this puts downward pressure on the exchange rate. As the exchange rate is fixed, the government has to intervene in the market by buying up its own currency using U.S. Dollars. This is an involuntary purchase, since the government has no choice but to accommodate the demand for foreign exchange at a given exchange rate. Capital outflows under a fixed exchange rate regime can decisively be called capital flight, as the country is losing reserves to abroad.
Let’s take the earlier example once again. Air India buys a plane from Boeing for ₹1,000 crore. Since the exchange rate is fixed, there is no depreciation. They keep buying more planes since there are no currency depreciation costs.
The other side of this is the Indian government drawing down its reserves to maintain the exchange rate. As the foreign exchange reserves dwindle, the government will have to borrow abroad. Foreign investors become unwilling to take local currency denominated financial assets given the prospect of future devaluation. Eventually, the country runs out of reserves and is forced to devalue or float the exchange rate. In the process, it becomes indebted in foreign currencies.
Thus, you can clearly see that current account deficits behave very differently under a fixed exchange rate system when compared to a floating exchange rate system. India has had a managed floating exchange rate since 1991, so any attempts to buy too many U.S. Dollars will result in depreciation and related adjustment instead of the state being indebted in foreign currencies.
The worst-case scenario, foreign currency indebtedness
The worst-case scenario for India would be if the U.S. forces India to take on U.S. Dollar denominated debt for political reasons and use those Dollars to prop up the exchange rate.
It goes like this. The U.S. says India “must” take a $500 billion loan from it to finance imports from the U.S. India, as in the Indian government, then uses these Dollars to buy oil, planes, or whatever the U.S. wants India to import.
India can also use the loan to temporarily prop up the exchange rate and keep it stabilized. However, it will eventually run out of reserves and be forced to float the exchange rate. It will now be stuck with $500 billion worth of debt which it has to service. The debt service will swamp the balance of payments and put continuous pressure on the exchange rate, raising domestic prices continuously. This can potentially lead to hyperinflation as well.
I do not believe this is going to happen, but it must be kept in mind. Sovereign foreign currency debt is dangerous.
Neoliberal export-led growth
The neoliberal era post-1991 has been characterised by the whole world giving the U.S. access to their real goods and services in exchange for financial claims. This has resulted in the world accumulating massive amounts of U.S. Dollar denominated financial assets.
This was tolerated by the U.S. because it allowed the deindustrialization of the U.S. (which, as I will talk about later, was a policy choice) and helped tame inflation (because cheap resources from abroad help dampen inflation).
India, for example, gives large amounts of goods and services to the U.S. in exchange for U.S. Dollar denominated financial assets. Why do India and others tolerate this? Because neoliberal ideology promotes exports as a virtue and because exports enhance profits without the government having to run larger deficits instead, which is considered bad under neoliberalism.
Under this framework, growth driven by internal demand and government spending (except for some capital expenditure) is considered bad, while exports are treated as virtuous. However, this is not something every country can do. For every net exporter, there must be a net importer. For China to have net exports, the rest of the world must be willing to net import from China by giving financial claims China is willing to accept. Countries do not produce for production’s sake; they produce so people can consume the goods being produced. A country is not a business that exists solely to turn money into more money. While that logic may apply to individual businesses, it does not apply to a country as a whole.
Now it turns out the U.S. no longer wants to be a net importer, or rather, the U.S. government does not, claiming that the U.S. accumulating its own currency instead of real goods is somehow more beneficial. Of course, Trump may not get his wish completely fulfilled, since other countries running on an export-growth mindset will try other measures like allowing more currency depreciation or, worse, internal devaluation, to export more real goods and services to the U.S. while getting fewer financial claims.
Trade, especially with an open capital/financial account, is not something that is in the control of the U.S. government. Private actors and other governments decide whether to export to the U.S.
Since the imposition of Trump’s tariffs, many countries, including India, have been trying internal devaluation policies, axing job guarantees, fiscal transfers, and cutting government spending in general. The purpose is to reduce unit labour costs and allow a country to export more without altering the exchange rate much. The obvious downside is that domestic demand and employment are undermined, while the U.S. and others get to maintain or improve their absorption of foreign goods.
Displacement of local production
Many on the left and the opposition have criticized the U.S.-India trade deal as undermining the sovereignty of India. While there are definitely very sensitive political aspects to it with respect to India cutting oil imports from Russia entirely, with Trump passing an Executive Order saying the U.S. will monitor India’s oil imports and impose 25% tariffs if India dares to do it, I wish to get into the import aspect which has been raised by many in the opposition.
The U.S. is claiming the lowering of tariffs by India on imports of certain agricultural products will allow it to capture more markets. This represents a very mercantilist way of thinking, seeing exports as a good thing. One has to ask, if the U.S. is producing so much dairy (for example) than it needs to, why not cut production instead of giving it to other countries (like India)? The labour from the production being cut can be used to produce goods which the U.S. needs instead.
The answer should be obvious, the U.S. runs on neoliberal capitalism where exports add to profit and employment. American ‘farmers’ make additional profits from exports while people stay employed.
The issue is, India also operates under a similar regime. American agriculture is highly subsidized by the U.S. Government and very productive, their low-cost agriculture could displace local production under a market system, making local production difficult and resulting in loss of output and employment.
The key phrase however is ‘market system’. The only reason why imports displace local production is because the Government does not use fiscal policy in a way to counter negative effects of imports on prices. Under market capitalism, there is very little downwards price flexibility. If the Indian Government simply decided to buy up all the milk produced locally at a fixed price (the MSP), distribute for free or subsidized as well as also ensure that the farmers will be provided with a basic job, then imports will stop displacing local production.
The opposition’s argument that certain American imports will displace local production if tariff barriers are removed is true, but only under a market system where the Government does not intervene. That is unfortunately the system we live in right now, the Government does not intervene and the downwards pressure on prices of agricultural prices, instead of allowing everyone to consume more (India has some serious nutritional deficiency issues) we have a situation where farmers are forced into unemployment and the country loses some local production of essential goods like food.
Net Transfers vs Current Account Deficits
Let’s say a country receives $500 billion from the U.S. as transfers under foreign aid which can only be used to import certain goods from the U.S.
Now, let’s say a country receives $500 billion from the U.S., but it also gives ₹45 trillion INR to the U.S., which it then uses to import certain goods from the U.S.
One would say both are different, since in the latter case the country’s net worth did not increase. This would be somewhat wrong. In both cases, the country receives real goods and services from the U.S. without giving any real goods and services to the U.S.
The only difference is in the second case: the U.S. gets Indian Rupee denominated financial assets. These assets are not convertible in the sense that the Indian government does not promise you anything for them. Rupees are just Rupees, nothing more. So, in order for the U.S. to get its own currency, the U.S. Dollar, it will have to go to the foreign exchange market, and as the rate is floating, it will be limited by liquidity and price.
So, the real terms of trade go in favour of India in both cases. In fact, that’s what the U.S. has actually been doing since the 1980s. It has run gigantic current account deficits, with China, Europe, and other exporters accepting U.S. Dollars (its own currency) for real goods and services. In fact, it would be very similar functionally if China, for example, gave the U.S. ¥20 trillion and told the U.S. to buy whatever they wanted, but this would look different appearance-wise since this would be a net fiscal transfer. But functionally, a current account deficit and a net transfer are very similar under a floating exchange rate regime.
Conclusion
- Trade deals can’t override balance of payments reality. Imports must be financed, and exchange rates will adjust until imports, whatever remains at the depreciated rate, can be financed.
- Under a floating exchange rate, a trade deficit means the country gets more real goods and services than it’s giving. Under fixed or politicized financing, there is a risk of a foreign currency debt trap.
- The issue isn’t the trade deficit itself, but neoliberal economic policies which leave the country’s local production with no backstops.
That’s all.