Economic security in an insecure world needs revamped risk architecture

What's needed is a revamped economic architecture predicated on proactive risk management and improved shock absorption

Over the last decade, the world appears to be in a permanent state of disruption — marked by geopolitical conflicts, trade wars, reconfiguring supply chains and, more recently, galloping technological progress whose 

promise of productivity is matched only by its peril of job displacement.  

Technological progress is inexorable but the rest of the disruption should not be a surprise. The old geopolitical and economic order has broken down and the world is lurching — one crisis at a time — towards a new, unknown equilibrium. The consequence: Sins of commission and omission. Not only is the current world disorder itself engendering more instability but it is also precluding a unified and coherent global response to the existential challenges of our time — pandemics, 

climate change, AI, income inequality, job insecurity. 

From the perspective of small and middle powers, a hostile global backdrop is an exogenous setting, immune to their individual (if not collective) actions. In economic parlance, middle powers are largely ‘price takers’ in this environment. So, if countries cannot influence the frequency and severity of shocks, how best can they respond?  

Building economic security in this environment should be a paramount objective but will entail both a tactical and a strategic dimension. Tactically, countries will need to more proactively and holistically identify economic chokepoints and mitigate risks where possible. But tactical risk-management will need to be complemented by strategic re-thinking — creating a domestic economic architecture that is more shock-absorbent and better able to reallocate resources in the face of shocks. Put 

differently, economic systems will need to upgrade, adapt and evolve to confront the changed reality. 

Identifying chokepoints and mitigating risks 

What are the implications for India? In a world where supply chains have become fragile and trade is being increasingly weaponised, India must start by systematically identifying chokepoints and vulnerabilities.  

It is well known now that 90 per cent of India’s liquefied petroleum gas (LPG) flowed through the Strait of Hormuz and almost 50 per cent of India’s liquefied natural gas (LNG) came from Qatar.  

But other chokepoints also exist. About 70 per cent of India’s Active Pharmaceutical Ingredients (APIs) are sourced from China with some estimates that this ratio rises to almost 90 per cent for antibiotics. Meanwhile, almost all of India’s polysilicon (used for solar panels) and more than 90 per cent of its lithium-ion batteries are imported from China.  

All this suggests too much concentration risk, and a multi-pronged approach will be necessary to mitigate these risks:

Build buffers: India must build broader and deeper physical buffers for critical inputs. Both Korea and Japan had more than 100 days of strategic crude reserves, quite apart from what the commercial sector possessed, in the run-up to the Iran war. On its part, China has strategically built stockpiles of crude, natural gas, industrial metals,critical minerals and rare earths over the last decade, to protect against a rainy day.  While that scale and scope may not be feasible for India, the principle is worth pursuing in high-vulnerability areas. 

Diversify imports: Buffers are important when there are global shortages. But to prevent against import concentration from any one country, diversifying imports across multiple economies is crucial. We should be buying more LNG from the US and more LPG from Australia, for instance.   

Hedge prices: Volume risk apart, India must hedge price risk in financial markets where possible. Mexico’s government actively hedges its oil exports using put options in financial markets (the ‘Hacienda Hedge’). Why can’t India hedge its crude imports to prevent against large swings in oil prices — and the uncertainty they engender on inflation, fiscal and the current account? 

Allow FDI from China: What happens when you are dependent on Chinese imports and there are no substitutes because China has a virtual monopoly in key sectors? One way to hedge that risk is to welcome more Chinese FDI into India to create domestic production capabilities. This will, over time, result in some transfer of technology, create domestic jobs and reduce the risk of relying on imports that can be weaponised. The recent relaxation of Press Note 3 is a start but much more needs to be done. 

Assessing vulnerabilities, however, should not be limited to what we can see and touch. Mythos has set the cat among the pigeons. How vulnerable are India’s digital systems to bugs and cyberwarfare? What can be done to build protection and redundancies?  

A starting point could be a multi-disciplinary war room, set up across the public and private sector to identify chokepoints and vulnerabilities across the economy and suggest mitigating actions.

Make no mistake — risk identification and mitigation will come at a cost. A fiscal cost, an opportunity cost, an efficiency cost. But it’s akin to paying an insurance premium to ward off the larger costs of an accident. 

Risk mitigation should not lapse into import substitution 

It’s crucial, however, that we do not conflate risk mitigation and economic security with autarky and import substitution. 

The growing temptation in this environment will be to lapse into import substitution — under the guise of resilience. One can easily envision the following argument: The best way to mitigate import risk is to produce the bulk of the supply chain domestically. Industrial policy should therefore be used to guide the private sector to help create large swathes of self-sufficiency. The theory of comparative advantage must be sacrificed at the altar of resilience in these epochal times. 

We must strongly resist those impulses for a number of reasons: First, risk mitigation does not warrant recreating entire supply chains at home. This will be a gross misallocation of resources and akin to throwing the baby out with the bathwater, as our own economic history has revealed. Instead, risk mitigation simply involves identifying parts of the supply chain that India is most vulnerable to and mitigating those specific risks.  

Second, just because the world has become a more dangerous place does not mean we retreat from global engagement. For India to grow at 7-8 per cent for the next two decades — if we are to come close to becoming an upper income economy by 2050 — we must embrace exports (goods and services) more wholeheartedly.  As history has shown, no country has grown at that pace for that length of time without harnessing exports. But exports require imports which, in turn, will necessitate lower tariffs and non-tariff barriers. The challenge and paradox, therefore, is for India to become even more open to trade — both on the export and import front — even while working actively to mitigate trade-related risks. There is no inherent contradiction between the two.    

Third, the allure of using industrial policy (IP) — under the guise of promoting resilience — should be resisted. In a world governed by complex, dynamic and rapidly evolving production techniques and supply chains, policymakers picking winners and losers also carries the same risk of resource misallocation. According to NIPO (New Industrial Policy Observatory) data, not only have IP interventions around the world surged post-pandemic but countries are increasingly resorting to ti  t-for-tat IP. This is akin to a modern day Prisoner’s Dilemma, where each country’s actions nullify the other’s, so nobody gains a competitive advantage but everyone pays a fiscal and resource allocation cost and is therefore worse off.  Where IP has worked it has been accompanied by simultaneously increasing competition. Furthermore, the costs of IP should not be underestimated. China — which is seen as the poster child of IP — is estimated to spend almost 5 per cent of GDP on support. 

Think of the opportunity cost of those resources. 

Instead, industrial policy should be used very selectively only for national security and strategic purposes. Here too, the bar needs to be high. National security justification is often the first refuge of the protectionist. 

Economic security, more generally, has to transcend narrow risk mitigation. Instead, it needs to broaden to create an economy that can both better absorb shocks and reallocate resources, themes to which we turn next.  

Shock absorption, fiscal buffers and safety nets 

A key element of shock absorption is to always retain fiscal degrees of freedom by maintaining fiscal buffers. These are important not only to cushion against repeated shocks but also to act as a springboard to make crucial investments  (human and physical capital, green transition, safety nets) for the brave new world we are entering. In India’s case, with public debt at almost 85 per cent of GDP, fiscal degrees of freedom are uncomfortably constrained in the wake of potential shocks. The Centre has assiduously reduced its fiscal deficit in recent years, only for it to be partially undone by widening state deficits. A combined deficit of almost 7.5 per cent of GDP six years after the pandemic appears too elevated.  

Our fiscal work is therefore cut out. Better shock absorption will entail creating more fiscal space, recrafting safety nets and repurposing spending towards strategic priorities. Should we contemplate an urban safety net (e.g., temporary urban unemployment insurance) to stop the mass migration of urban labour back to the villages every time there is a shock? More generally, should we redesign our welfare nets to be targeted, temporary and state-contingent rather than broad, permanent and untargeted product-based subsidies?   

Can we arrest the rapid proliferation of cash transfers at the state level — synchronised with the electoral cycle — and redirect those resources towards more strategic priorities, such as human capital augmentation? Are different fiscal incentives needed to accelerate renewables, which is the best long-term antidote to reducing our dependence on hydrocarbon and fossil fuels? These are the strategic questions that fiscal policy will need to increasingly grapple with.  

The coming creative destruction 

Finally, strategic shock absorption needs to extend beyond fiscal policy. The sheer pace of technological change — and both the dynamism and disruption that it promises — suggests  a wave of creative destruction is coming. This, alongside the recalibration of supply chains — in response to trade and geopolitical developments — suggests a lot of churn is in the offing. Navigating this will require economies and societies to be nimble, shock absorbent and able to quickly and efficiently reallocate 

factors of production. Rigidities that prevent capital and labour from moving more seamlessly from sunset to sunrise industries will need to be urgently addressed. Regulatory cholesterol that prevents both the timely set-up and exit of firms will need to be quickly reduced. Doubling down on re-skilling, re-training and continuing education, and protecting those that are left behind, will need to be mandatory.   

The calm seas of the last few decades have been replaced by an enduring storm. Economic security in this world will entail identifying and mitigating risks but, more broadly, creating an economic architecture that more effectively absorbs shocks and more efficiently reallocates resources. Importantly, we need to build these capacities without turning inward and becoming cynical about global trade. This will entail striking a fine balance in policymaking – one that is necessary to simultaneously achieve high growth and become more shock-resistant.  

The task is both daunting and urgent but, then again, these are not ordinary times.   

 

The writer is head of Asia economics at J P Morgan. Views are personal.