Free Trade: New Challenges Ahead

Free Trade: New Challenges Ahead

On the 23rd of June 2016, the British people decided to leave the EU, the only geographical area that almost completely fits the textbook definition of free trade, i.e. “the economic policy of not discriminating against imports from and exports to foreign jurisdictions.”. They made this decision official on the 27th of March, and lots of interrogations remain about the new agreements between the EU and Great Britain. In fact, a NatCen study shows that 88% of Britons back free trade, but 69% of them also support customs check and a harder immigration policy. This, associated with a lot of privileges like passporting no longer being available to British based companies, would push talents away, and ultimately entail less growth and innovation in Great Britain. But this is only one of the many possible scenarios. As said before, the EU is the only really integrated area. In the rest of the world, there exist many obstacles to free trade such as quotas, restrictions, subsidies or prohibitions. Barriers like the ones named here do not seem to negatively impact economic growth or innovation: China has practiced protectionism since 1978 when it decided to become a market economy, and yet its GDP is still growing at a rate of about 7%!

China GDP

Even developed economies have used protectionism and strong barriers to free trade to develop: during the 18th and 19th centuries (and even until WWII for the US), protectionism was seen as the only way to increase wealth and protect your interests against the ones of other countries. International trade was not seen as a win-win game but more as a zero-sum game, where for someone to win, someone must lose.

tariff rates

Anyway, already in the 19th century economists such as David Ricardo or Adam Smith declared and proved that free trade is the best possible solution for economies to thrive and grow. In response to their research, and because economies started to open up as a result of industrialisation and the facilitation of commerce and transportation, free trade became the norm and regulation became lighter and lighter. For instance, tariffs shifted from an average of 50% of the total imports in the US in 1830 (sometimes even more depending of the product) to an average of 3.8% in developed countries. After the Uruguay round of 1995, the proportion of imports into developed countries from all sources facing tariffs rates of more than 15% declined from 7% to 5% and the WTO set up piles of regulation on tariffs. (The WTO tariff agreement report is 22,500 pages long!)

The creation of the WTO in 1995 combined with globalisation really helped reduce the obstacles to free trade, but some still exist. In this article, we will therefore analyse the still existing obstacles to free trade and more importantly their impact on the global economy. Free trade is first and foremost a political choice, and consequently the largest part of the obstacles to free trade are political too and can take the form of quotas, tariffs, or other restrictions.

According to Robert Feenstra in Advanced International Trade, they are three main reasons why a country would impose tariffs: to protect fledging domestic industries from foreign competition, to protect aging and inefficient domestic industries or to protect domestic producers from dumping by foreign companies or governments. These three justifications of some level of protectionism can seem inoffensive, but as reported by the World Bank, if all barriers to trade were eliminated, the global economy would expand by about 830 billion dollars.

When looking at such number, it seems evident that it comes from the extra costs induced by the countries which are imposed with tariffs, but countries imposing tariffs also generate extra costs that usually outweigh the benefits. Indeed, when imposing a tariff, countries usually expect a rise in production and prices (due to lower competition), and this should induce producers to hire more workers which will automatically cause consumer spending to rise. But in the vast majority of cases, the rise in price will mean a decrease in purchasing power for the consumer. As a response, he will either buy less of the good which price has increased or less of another good. In any case, the increase in price will affect negatively global demand, and logically, it will also impact growth. Let’s think of the UK for instance: Brexit has become official of the 27th of March, but it should not be completed before 2019, and yet prices already started to rise[1], and growth expectations are rather negative[2].

Furthermore, tariffs and other restrictions can be used as a very powerful weapon in an economic battle. Such battle started for instance between the EU and the US in 1989, when the EU decided for sanitary reasons to impose heavy restrictions on American beef grown with hormones. In the first year after the tariff was instituted, about $140 million worth of American beef was blocked.  In 2008, the WTO decided that the EU had no legitimate reasons to impose and maintain such restrictions, and therefore the US were allowed to impose retaliatory import duties on EU products if the ban was not lifted. The EU decided not to lift the ban, and the US imposed supplementary restrictions to European products such as canned tomatoes, French cheese or ham. All products banned had a market value of $38 million but under the WTO ruling, the US could raise the tariff barriers to a value of $116.8 million, that is an additional $79million. These numbers show immediately what countries can lose due to tariffs and other restrictions, but the real victims of such games are consumers. As said before, because of tariffs which induce lower competition, price increases, but in addition to higher prices they are also confronted with less choices: in the USSR for instance, which is an extreme example of what barriers to free trade can do to an economy, people had very few choice for basic products such as dairy products or linen etc. even if due to communism they did not face higher prices. This lack of choice, associated to an increasing attraction towards western products, was one of the reasons for social unrest in the USSR and eventually for its collapse.

However, even if on the long run tariffs and barriers to free trade are harmful for the global economy, they do not only have a negative impact; they have always been used (and still are) by developing countries to increase government revenue and boost investment and growth. The strategy China used for its development nicely clarifies this statement.

It started developing in 1978, when it initiated market reforms and shifted from a centrally-planned economy to being market-based. GDP growth has averaged nearly 10 percent a year and has lifted more than 800 million people out of poverty. To achieve that, China has used a classical technique that we could describe as the “infant industry” argument. As said before, tariffs can be used to protect a domestic industry against foreign competition. When countries start to develop, it is common knowledge that they should protect domestic industries until they become profitable: at the beginning of its development, China imposed heavy restrictions and tariffs, with absolutely no subtlety. Some western products were simply banned with no further explanation. When it joined the WTO in 2001, it had to change its policy and adapt to the standards of the organisation, but restrictions are objectively still very heavy. The Custom General Administration (CGA) assesses and collects tariffs, which are divided in two categories: the general tariff, and a minimum one for “most-favoured” nations such as the US, who have a commercial agreement with China. On top of paying tariffs, imports are also subject to a VAT of 17% or a business tax.

Quotas also still limit over 40 categories of products such as watches, automobiles, or and in 1996, China introduces tariff rate quotas (TRQ) on imports of wheat, corn, rice, soybeans, and vegetable oils and out-of-quota rates can still be as high 121% of the market value of the product. Certain commodities still have an automatic registration process, the inspection standards (especially for commodities) are very high while the legal framework is much more general than in most OECD countries, which allows the Chinese government to use it in a very flexible way. This may result in inconsistency and companies have real trouble understanding whether they are breaking rules. Certain sectors such as textiles also have to pay extra import taxes. Services remain even more regulated, since it is a sector that China wants to develop and protect from foreign competition. As a matter of fact, foreign services providers are largely restricted to operations under the terms of selective “experimental” licenses, and have to face strict restrictions on entry and on the geographical scope of the activity. This severely limits the profitability and growth of such activities.

GDP by sector

As we can observe from this graph, this strategy of the “infant industry” was very efficient for China and allowed it to experience the fastest sustained expansion by a major economy in history. But as research as shown, protectionism can only be a temporary policy; in order to have a sustainable growth, a country has to open up and reduce barriers to free trade as much as possible. And de facto that is exactly what China is trying to do. At the end of January 2017, China’s State Council announced it would further open some sectors such as mining or services to foreign investments. Besides, China is expected to import $8trillion worth of goods and services within the next five years, and Chinese outbound investment should reach $750 billion over the same period.

Ultimately, free trade seems to be the path that all nations should follow to maintain sustainable and strong growth as China demonstrates. Even though physical obstacles to free trade still exist under the form of restrictions, quotas, etc. China is willing to reduce them and to open its doors to foreign companies and investments. As President Xi Jinping said in Davos: “China will keep its doors wide open. We hope that other countries will also keep their doors open to Chinese investors and maintain a level playing field for us.”. This last sentence was a direct attack to President Donald Trump, who some days earlier declared a trade war against China which he accuses of toying with its currency.

The election of Donald Trump, whose campaign slogan was “Make America great again”, and who intends to fulfil this by instating a much more protectionist policy, as well as Brexit are two symptoms of a greater illness. In fact, if free trade has not won over the entire world yet, it is mainly because people are afraid of foreign competition. They have the feeling foreigners will try to take their place and replace them, leaving them with no jobs and no opportunities. Especially in countries such as the UK or the US, where income inequalities are important and have increased since the financial crisis of 2008[4], people tend to show more protectionist tendencies. Populists such as Donald Trump or even Marine Le Pen in France have understood this phenomenon and use it in their campaigns to win over voters. But as Xi Jinping said during the World Economic Forum in Davos this year, “many of the problems troubling the world are not caused by economic globalisation. During the same event, his compatriot Jack Ma, founder of Alibaba and richest man in Asia agreed, saying that globalisation is good. But he also said globalisation should be improved, it should become inclusive in order to guarantee that everyone can benefit from it.  Especially in a context of slowing growth, the voices against globalisation are easier to hear, because the benefits are harder to distribute, but we should not forget that globalisation has powered global growth, and facilitated advances in sciences, technology and civilisation. Xi Jinping concluded this way, and so will we: “Pursuing protectionism is just like locking oneself in a dark room; while wind and rain may be kept outside so are light and air. No one will emerge as a winner in a trade war.”

Author: Elsa Leger

[1] Oil prices have gone up since the officialization of Brexit on 27th of March, growing from around £48 a barrel to £53 on 10th of April.

[2] Fitch Ratings still grades the UK AA but decided to put a negative outlook after the 27th of March.

[3] It is probably no coincidence that this new policy was decided when China’s growth started to slow down due to a decrease in domestic demand.

[4] According to the Gini Index, which ranks countries in accordance with the level of inequalities, The UK and US have a coefficient of 0.34 and 0.37 respectively. The European average is about 0.3, and Turkey has a coefficient of 0.40.

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India: A brief analysis of the world’s fastest-growing economy

India: A brief analysis of the world’s fastest-growing economy

We are living really hard times. The fear caused by the growing terrorist activities, the distrust of the stranger induced by rising nationalisms and by a propaganda good at riding the wave of growing frustration, the uncertainty caused by the dissolution of our certainties. Many are the reason that keep investors awake and contribute to the current atmosphere of  anxiety and restlessness.

Nevertheless, there is a safe-haven which seems to be insulated by all these factors and that is living the most prosperous period of its history. A tireless nation that continues its seemingly unstoppable growth process. A bright spot of positive two-digit returns in a world of incredibly low yields.  We are talking of course about India, the fastest-growing large economy in today’s world, whose economy grew at an incredible rate of 7.5% in 2015 – faster than the 6.9% growth observed in China, the former leading emergent economy and currently the third largest economy after the US and EU – and is still expected to grow at 6% in 2020.

Since the Republic constitution in 1950, Indian economy was characterized by heavy state regulation and intervention and by protectionist policies that kept it off from the outside world. In 1991, an acute balance of payments crisis – due particularly to the currency devaluation and the high budget deficit – forced the government, led by Narasimha Rao[1], to liberalize the economy moving toward a free-market and capitalist system.

The large population, the bustling manufacturing sector, the high saving rate and the emphasis on foreign trade and direct investment inflows, contributed to a rapid progress, with an incredible average rate of about 5% GDP growth since then. We can easily see how an investment in the Indian stock market made ten years ago, would have more than doubled our investment. Actually, the chart below compares different stock market indices. We can notice at a glance how both the Sensex and the Nifty (indices of the two Indian stock markets), with an average growth rate of 90%, have considerably outperformed the average of emerging markets (given by the MSCI Emerging Markets Index). Only the S&P500, with a return of 67%, has almost kept up with such huge returns.

STOCK Markets

Since the election of Narendra Modi as prime minister in May 2014 – after a controversial campaign in which the leader of the Bharatiya Janata Party focused on fighting corruption and sustaining economic development – we assisted to a progressive liberalization of the economy, mainly aimed at increasing the attractiveness for foreign businesses. The labor market was deregulated (to make it easier for the employers to hire and fire workers and harder for them to form union), corporate taxes and customs duties were lowered, the wealth tax was abolished, digital infrastructure were built – through to the “Digital India” campaign – and more Foreign Direct Investments (FDI) were allowed in areas like Construction Projects, Cable Networks, Agriculture and Plantation and Air Transportation. The shadow economy has been harshly limited by the demonetization of all ₹500 and ₹1,000 banknotes, in order to crack down the financing of terrorist and illegal activities. A new “Insolvency and Bankruptcy Code” has been issued on May 2016. At last, the huge problem of different taxation between different regions –  past cause of confusion and uncertainty – is being solved as today is under review the single biggest tax reform under the ‘Goods and Services Tax’ or GST bill, whose aim is to create a consistent tax structure across the entire country and one single marketplace.

Moreover, the following initiatives were launched: “Make in India”, to encourage foreign companies to manufacture products in India; “Standup India”, to support entrepreneurship among women and SC and ST communities (Scheduled Castes and Scheduled Tribes); “Startup India”, aimed at promoting bank financing for start-up ventures to encourage entrepreneurship and jobs creation. Large investments have been made in Africa in sector as energy, mining and infrastructure, with the main purpose to reduce the dependence on imported goods such as oil, coal and gold (almost 50% of Indian overall imports).

Furthermore, Modi achieved a drastic reduction of the budgetary deficit – from more than 4% to 3% – at the expense of the funds invested in environmental and social programs as poverty reduction, family, healthcare and education (reduced by almost 15%). As a result, we assisted to an enlargement of inequalities in income distribution[2], mainly because rising inequalities between urban and rural areas.

The economy was spurred even more by the consecutive rate cuts pursued by the Reserve Bank of India, as a response to the preoccupant level of inflation observed at the end of 2013, which reached the peak of 11.5%. The repo rate was lowered from 8% to 6.25% in less than two years.

The measures achieved soon the expected results, boosting the economy (GDP grew at the incredible rate of 7,5% after Modi’s first year as prime minister) and increasing much the attractiveness for foreign companies. The amount of Foreign Direct Investments jumped from $34 billion in 2014 to $44 billion in 2015[3], the unemployment rate dropped to 6.3% in 2016, the time required to start a new business dropped from 33 days to the current 26. Therefore, the IPO activity is expected to rise by more than 40%, while M&A activity should more than double in 2019, above all in sectors as financials, consumer and healthcare. Among the countries with the largest share of FDI inflows to India we can find in first position Singapore, followed by Mauritius Islands and United States. Among the European countries, Netherlands is first in rank, followed by Germany (whose car manufacturers are outsourcing part of the production), UK and France. The main reason behind the huge amount of FDI from Mauritius Islands and Cyprus is the low taxation of these two countries – considered tax heaven – which induced many Europe and US based companies to route their investments into India through these countries, deriving double tax avoidance and tax evasion. By the way, with the renegotiation of the double taxation avoidance agreement (DTAA) with India, this phenomenon is likely to decrease soon.

There are other positive factors behind the Indian growth that justify good expectations. Differently from China, Indian growth has been sustained above all by its internal consumption and a fast-growing middle class[4]. Moreover, we can consider such growth as approximately unleveraged[5]. Therefore, the country can easily increase its debt issuance in the near future, especially considering the high rating of BBB- confirmed by Fitch last summer. Third, the expansion has been demographically propelled. Today, India has still a population growth rate of 1,26%[6], thus by 2050 India’s workforce (people between 15 and 59 years old) is expected to have grown from the current 674 million to a staggering 940 million. On the contrary, China is likely to be facing a shrinking workforce, which will potentially drive up labor costs, undermining its competitiveness against other cheap-labor countries. As a matter of fact, India is already much cheaper with an average hourly rate of only 0,48$ per hour[7], largely due to the very low level of gross domestic product per capita[8]. We have to consider also its people’s ability to speak English and its large pool of computer engineering graduates, which make India a popular destination for outsourcing activities.

As we could see, with the advent of N. Modi as prime minister, many are the initiatives carried forward to increase the attractiveness of India. The results so far are extraordinary and India can really overtake the US as the world’s second largest economy by 2050 according to a recent report published by PricewaterhouseCoopers (PWC).

Nevertheless, many challenges are still ahead. The education sector needs to dramatically improve its quality. Considering the future increase in population, the push to allow more private universities and to allow foreign universities to operate in India will strengthen.

Another crucial point is the delay in the spread of Internet and the smartphones. From this point of view, China has a great advantage against its rival. Since 2013, the Chinese have consistently reported rates of internet and smartphone use that are at least triple that of Indians (71% of Chinese adults report using internet occasionally, against the 21% Indians). The gap is similarly large when it comes to social media use[9].

Much will depend also on the foreign policy that could be pursued under Trump’s presidency, as the US, second largest trading partner of India, count for more than the 15% of Indian exports[10].

Last but not least, the conditions of women are still far by those of civilized countries. Although the Supreme Court of India said that ‘equal pay for equal’ work is an unambiguous constitutional right, the implementation is resulting very difficult[11].

The world is changing fast. Everything seems to be uncertain and unpredictable. One thing is certain, India will not stand by but it will play a leading role.

AUTHOR: Niccolò Ricci

[1] Narasimha Rao was an Indian lawyer and politician who served as the 9th Prime Minister of India, from 1991–1996.

[2] The income inequality reached the worrying level of more than 50% according to the Gini Index. Only China had greater inequality at that time.

[3] An impressive increase of almost 30%! India is currently the first country for FDI after China and US. World Bank Data.

[4] India is ranked 128th according to the Index of Economic Freedom , meaning that the country is less dependent on the external demand and thus more insulated by global evolutions.

[5] Indeed, in 2015 domestic credit to the private sector (percentage of GDP) stood at 52.6 per cent for India, compared to 153.3 per cent for China. Also the government debt is very moderate, with a ratio of roughly 70%.

[6] Well above the rate of China (0,52%) and aligned to those of most African countries, despite the higher degree of development.

[7] “Countries with the cheapest labor”, The Richest. The cheapest country in the world is Madagascar (0.18$ per hour), followed by Bangladesh, Pakistan, Ghana and Vietnam.

[8] India is ranked only 122nd globally (about 6.000$ per person, against an average of 15.000$), World Bank Data.

[9] According to the Spring 2016 Global Attitude Survey, by PEW Research (www.pewresearch.org).

[10] China is the largest trading partner of India, followed by USA, United Arab Emirates, Saudi Arabia and Switzerland. Department of Commerce of India.

On the other hand, India is the main counterparty of Buthan, Guinea-Bissau, Nepal and Afghanistan. CIA World Factbook, 2015.

[11] According to the Gender Gap Index 2015, set by the World Economic Forum, India is ranked only 108th. Iceland leads this special rank.