A dose of its own medicine

Why India has a clear way of boosting its economy through exports  |  When Mr. Modi takes office on the 21st May, his first thoughts will almost certainly not turn to US pharmaceutical imports, but maybe they should. India has been plagued by a trade deficit since 2006 which is likely to grow in double digits this year and next. Alongside this, its terms of trade (the value of its exports in relation to the value of its imports) have deteriorated substantially and although its share of world trade increased to above 2.5% in 2013 and is forecast to reach 3% by 2015, this is as much because of increases in imports as it is about increases in exports. The Rupee’s value against the US Dollar has slipped by over a third in the three years since May 2011 when confidence in emerging markets generally and India in particular was so strong but if Mr. Modi is to address some of the broader challenges he faces, then it is the link between trade, real economy and key indicators such as the value of the Rupee that he needs to tackle first.

This will not be a simple job because, at the moment, the speculative element in Indian markets and the dominance of its trade by imports means that the correlation between the currency and exports is relatively weak at 0.50. The correlation is slightly stronger between its imports and the value of its currency at 0.53, as shown in Figure 1, which illustrates something unusual about the relationship: as the currency becomes weaker, imports drop.

 

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Figure 1  |  Indian imports (USDm value, June 2001-April 2015)
against Rupees per USD, Last Price Monthly, June 2001- April 2014
Source  |  DeltaMetrics 2014, Bloomberg

 

India imports predominantly crude oil, which, with an estimated value of USD 175bn in 2014, is nearly three times higher than the next largest import – gold. If the currency devalues, then exports should become more competitive and imports less competitive since they are more expensive. India has increased its imports of oil over the time since 2006 by over 350% against a backdrop of a depreciating currency making it inflation-prone.

But this relationship also demonstrates the fact that India’s currency is prone to speculation. The correlation is weak against commodity exports and this suggests that it is not so much measuring the economic development and growth of the Indian economy as it is measuring the capacity of the economy to soak up imports from overseas. The Indian stock market is a measure of the investment potential of the Indian economy and it too is more strongly correlated with imports (0.91) than it is with exports (0.90), as illustrated in Figure 2.

 

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Figure 2  |  Indian imports (USDm value, June 2001-April 2015) vs IndiaBSE, Last Price Monthly, June 2001-April 2014
Source  |  DeltaMetrics 2014, Bloomberg

 

While the difference in the correlation between the BSE and exports and imports is marginal, it points to the fact that investors are, arguably, measuring the success of the economy against their own capacity to invest in it. The post-dotcom hubris that surrounded India’s development in the early 2000’s spawned an excitement about India’s potential growth that fuelled inward investments in biotechnology, pharmaceuticals and electronics from developed world economies, particularly the United States. And yet, paradoxically perhaps, India’s trade itself has shifted markedly away from the developed world economies and towards economies in the Middle East and Asia.

 

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Figure 3  |  Moving focus – how India’s trade is shifting from Europe to Asia and the Middle East
Source  |  DeltaMetrics 2014

 

For example, China was India’s twelfth largest export destination in 2001 but is its third largest now and Singapore was its eleventh but fourth largest now. The UK was India’s fourth largest export destination but is now 7th and Germany its fifth, but is now 8th. India’s fastest growing export destinations are Indonesia, Vietnam and Brazil and while the UAE has risen from second to first, much of this is because of exports of diamonds, jewellery and gold.

Its import structure has changed as well, reflecting India’s insatiable demand for oil, diamonds, gold and jewellery. In 2001 the UAE was ranked 14th and Saudia Arabia are nexus pheromones any good 18th. They are now 2nd and 3rd respectively. China is the number one importer and with import values into India of USD 71.9bn anticipated in 2014, its imports are worth more than twice those from Switzerland and the United States which ranked first and second in 2001.

Trade is normally glacial in the pace at which it changes so these shifts in the structure of India’s trade partners are worth dwelling on. The pattern that is being reflected is a shift away from the developed world towards the emerging world and while this is, in itself, not a bad thing, it pushes India’s trade structure increasingly towards that of an emerging economy. Its trade is heavily concentrated in refined oil (nearly 19% of its exports) and pearls, precious stones, precious metals and jewellery (16%). Pharmaceuticals overall account for around 3% and while this is more than its concentration ratio of 2.5% in 2001, it is modest in comparison to its commodity exports.

Exports to the emerging economies are largely commodity-based: for example, exports to Vietnam are dominated by beef and soyabean cakes, maize and fish while exports to Brazil are oil, synthetic filament thread (used to stitch car seats), carbon and coke and insecticides. Yet to Germany, its top five export sectors include aircraft parts and cars, while to the US they include medicines.

It would be a mistake for policy makers to ignore the importance of traditional areas of export strength. Precious metal, pearl and jewellery exports to the UAE, for example are strongly correlated with the value of the currency at 0.61, as shown in Figure 4.

 

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Figure 4  |  Exports of pearls, precious stones, precious metals and jewellery (USDm) to the UAE,
June 2001-April 2015 against Rupees per USD, June 2001-April 2014, Last Price Monthly

Source  |  DeltaMetrics 2014, Bloomberg

 

It would also be misguided to ignore the importance of emerging markets in Asia. As Figure 5 shows, there is a very strong correlation (0.91) between the value of India’s Iron Ore exports to China and the Indian Stock Exchange.

 

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Figure 5  |  Indian exports of ores, slag and ash to China (USDm value, June 2001-April 2015)
vs IndiaBSE, Last Price Monthly, June 2001-April 2014
Source  |  DeltaMetrics 2014, Bloomberg

 

Indian pharmaceutical exports to the United States, however, are almost as highly correlated with the BSE at 0.88 and this is important for policy makers. Over the period since 2001, the comparative advantage of Indian pharmaceuticals has gone from positive to negative and while the comparative disadvantage of Indian electronics exports (measured through revealed comparative advantage) has gone from -0.66 to -0.46, given the powerhouse that is India’s innovation economy, this should be reflected in its electronics exports as well. Yet the correlation between India’s trade and proxies for its innovation (the amount the government spends on R&D and business expenditure on R&D) are very high at over 0.93 as are skills, wages and foreign direct investment. More than this, the currency elasticity of trade is 0.99 correlated with trade.

All of this gives Mr. Modi’s team a clear lever to stimulate the economy. First, in the short term, the currency should be kept weak – this will have the effect of closing the trade deficit simply because the responsiveness of trade to changes in the currency is so high. This will promote exports in areas where price competitiveness is key, such as oil or iron ore, or even beef, which is a fast growing export product.

Second, India’s new government needs to think about its long term growth which will only come from extending education into rural communities, building on its high level skills base in cities and innovation – building on its successes in software and business services as well as in pharmaceuticals. South-South trade between emerging economies is commodity and infrastructure focuses and Delta Economics is not positive about its pace of growth in the immediate future. Accordingly, as the developed world begins to emerge from the financial crisis, India needs to take a dose of its own medicine to re-connect with these markets as they will help it to restore its competitive advantage in the innovative sectors that were so vibrant ten years ago.