Globalisation involves us all

A global comparison is instructive. The latest comparable data is for 2001. It shows that while international trade was 31 per cent of GDP in India, it was 29 per cent in the US and 24 per cent in Japan. India continued to lag China, which was at 53 per cent. In 2004, the current account alone works out to 40 per cent of GDP. So it is striking to see that India’s trade integration now well exceeds that of supposedly globalised countries like the US and Japan. If globalisation matters for them, it matters more for us.

These developments have far-reaching consequences. Our experience with the currency market and reserves build-up in recent years is a striking example of how we need to think in new ways. Traditionally, India had the attitude that it could pursue a target exchange rate and simultaneously have autonomy of monetary policy. But in the 1990s, we twice encountered constraints the rest of the world accepts. The “impossible trinity” constraint asserts that trading on the currency market and trying to have a currency policy inevitably comes with a loss of autonomous monetary policy.

When RBI actively bought up dollars to try to modify the exchange rate, this led to dislocations such as high domestic money growth, fiscal stress and speculative inflows of “hot money” into the country. In the 1960s and 1970s, which were formative years for most of us, we could have thought it possible to have a currency policy and have a monetary policy. But today, we have to realise that trading on the currency market interferes with domestic monetary policy. Globalisation constrains us. What was possible in a closed economy is not possible in an open economy. We have to decide which is more desirable for the country: monetary policy or currency policy. Most advanced countries, except for Japan, have confronted this choice, choosing to retain the power of monetary policy by giving up on currency trading. If RBI had not stopped trading on the currency market in April 2004, it would not have been possible to raise interest rates to combat inflation this month.

Another area where globalisation has major implications for policy is on the fiscal side. Globalisation means that factors of production — labour and capital — are mobile. A country with high rates of income tax suffers when smart people leave the country. A country with high rates of taxation of financial intermediation sees that financial intermediation leaves the country. Famous examples of this include the Japanese index futures market, and the Swedish government bond market, both of which migrated outside the home country in response to domestic policy problems.

A key principle of the globalised economy is that “we cannot export taxes” — that is, foreign buyers of local goods do not pay local indirect tax. Most countries, including Pakistan, Bangladesh and Sri Lanka, use the VAT principle, where imports are charged VAT at the point of entry, and exports are refunded all the VAT suffered on the raw materials purchased.

India’s exporters compete with firms in the rest of the world, which are all subject to such a modern VAT system. Our failure to build a sound VAT handicaps our exporters. Our exporters suffer from myriad “cascading taxes”, including octroi, entry taxes and a long list of cesses and duties. These drive up costs, and dealing with multiple paper-based tax authorities increases transactions costs. When exports take place, our exporters deal with a bureaucratic system of DEPB which is ridden with difficulties.

With a higher and growing trade/GDP ratio compared to the US or Japan, India is becoming a willing globaliser. No longer are imports and exports minor sideshows in the economy. Major efficiency gains and growth opportunities would accrue to India if we place our importing and exporting companies into a modern VAT regime, just like that faced by firms in other countries. Globalisation constrains us; it has increasingly taken away our flexibility of muddling along with a conceptually flawed system of indirect taxes.

These arguments apply equally at the state level. Andhra Pradesh competes with Gujarat for investment. It also competes with the Guangdong province in south China. Globalised firms send investment to locations where they face modern fiscal systems. AP no longer has the luxury of muddling along with a conceptually flawed system of indirect taxes or state VAT. This may seem like a “loss of autonomy” but it is the reality of the globalised world.

From 1986, we tried to meander along with incremental reforms which would move from excise towards VAT. We moved to MODVAT and CENVAT. We introduced the service tax. But the window of opportunity to make progress by small tinkering steps, without systemic reform, is increasingly closed. Besides, as India has become an open economy, the opportunity cost of tolerating an inefficient fiscal system has gone up. The end of the MFA and the enormous opportunity in textiles is just months away. Indian textile vendors will be up against Chinese competitors, who have had a sound VAT from 1994 onwards.

The 2004 Nobel prize winners, Kydland and Prescott, emphasised the importance of time-consistancy and credibility in economic policies. In a globalised economy with capital flowing in and out of the country, the need for consistency is even greater. By adapting our policy making we can reap richer dividends from globalisation.