Wide ranging, creative policy reforms needed to counter US trade shock

Wide ranging policy reforms are needed to counter American trade shock

In an overt display of politically motivated trade policy by United States President Donald Trump, India was targeted earlier this month with an exceptionally high cumulative tariff of 50 per cent. Almost a month later, with the penalty component now in effect, Indian exporters remain on tenterhooks, awaiting a positive —perhaps elusive — outcome of the Trump-Putin-Zelenskyy meetings and the rescheduling of stalled negotiations on a trade deal with the US. As the US is the largest market for our major exports, especially labour-intensive sectors like textiles and apparel, seafood, and gems and jewellery, a trade deal will need to be negotiated in due course.

 

It is, however, worth mentioning that almost all bilateral trade deals announced by President Trump thus far, other than the one with the United Kingdom, do not have a supporting legal text, are fuzzy on detail, and hence open to differing interpretations. The tariff stacking “mistake” in the implementation of the US-Japan trade deal and the “conditional” application of a 15 per cent tariff by the US on auto imports from the European Union, specified a month after the original announcement, are evidence of embedded ambiguities. A penalty tariff for transshipment of goods has been indicated in the deal with Vietnam but the corresponding rules of origin (RoOs) have not yet been specified. Continued negotiations and pending investigations under section 232 imply prolonged unpredictability in US trade policy. Also, US trade protectionism is likely to persist, given that the tariff hike during Trump 1.0 was not reversed by Joe Biden during his presidency. So, India’s trade policy response needs to be formulated with a longer-term vision.

 

As its foremost response, India needs to resist the temptation of looking inwards. Other than their contribution to overall demand, exports are a significant means to enhance manufacturing competitiveness and expanding productive employment — objectives that are critical to India’s development trajectory at this juncture. The share of manufacturing in India’s gross domestic product (GDP) has seen a persistent decline over the last two decades, from 17 per cent in 2006 to 13 per cent in 2024 (WDI, World Bank). Over the same period, India’s share of manufactured goods in its total goods exports has also declined, and in 2024, was around 64 per cent. In comparison, manufactured goods exports contributed over 90, 85 and 78 per cent in China, Vietnam and Mexico, respectively — all three economies that are also deeply integrated with global value chains (GVCs). GVC integration has been a significant contributory factor in their growing share of global manufactured goods exports, while India’s share has stagnated at less than 2 per cent for more than a decade.

 

To enhance manufacturing competitiveness through integration with GVCs, it may be useful for India, as a first step, to review the mandated minimum domestic value addition (DVA) in its flagship production-linked incentive (PLI) scheme. A specification of a minimum 50 per cent DVA to avail of the subsidy in certain sectors, including automobiles, auto-components and electric vehicles, while intended to encourage deep localisation, may actually be counterproductive. It is possible that domestic inputs are not available or, if produced domestically, may usually be high-cost substitutes. Over time, the high-cost production of import substitutes is likely to result in the elimination of small- and medium-sized producers and the strengthening of monopoly power among large domestic producers. It may be noted, over the last two years, several auto and auto-component producers in India have not been able to claim the financial incentive under the scheme, citing their inability to fulfil the mandated 50 per cent DVA and accompanying localisation requirement.

 

Keeping initial DVA targets at reasonably low levels and phasing out local content requirements can help lower production costs through the import of efficient and low-cost inputs. While making possible technological diffusion, imported inputs will also create competitive pressure and hence spur innovation. In the longer run, this leads to the creation of domestic capabilities and the technological upgrade necessary for establishing sustained manufacturing capabilities. This is reinforced by the experiential evidence from Southeast and East Asian economies, where a fall in DVA accompanied the increased GVC participation and the resultant manufacturing sector transition from predominantly raw material- and resource-based to intermediate-goods-intensive manufactured goods and exports.

 

In view of the above, a liberalised import regime is imperative for manufacturing sector competitiveness. A reduction in tariffs on imported inputs in the manufacturing sector as a whole, and particularly in sectors under the PLI scheme in India, needs to be undertaken. While the recent reduction in import duties on cotton is a step in this direction, a more comprehensive review of tariffs, as promised in the July 2024 Budget and initiated to a limited extent in the February 2025 Budget, now needs to be undertaken. India should aim to align its applied most-favoured-nation (MFN) tariffs in the manufacturing sector with those of competing Asean economies.

 

The necessity for lower import tariffs gains even more urgency in the face of an apparent review by the US of its “pivot to Asia” policy, wherein the geopolitical underpinnings for India appear less favourable and no longer derived from its positioning as a counterbalance to China. With the likelihood of continued US-China tech and trade competition, lower import tariffs will assist India in retaining its attractiveness as an alternative location for shifting GVCs and export-oriented, efficiency-enhancing FDI.

 

India will also need to diversify its export markets beyond the US. An early conclusion of a free trade agreement (FTA) with the EU, a review of the Asean FTA, and initiation of preparatory steps towards participation in the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) will contribute to this objective. With the recently signed FTA with the UK, India has a template to constructively move forward with both the EU and CPTPP. With the EU inclined to deepen its economic integration with the CPTPP, the expanded 39-economy trade bloc could well become the dominant rule-maker for global trade. It is equally important to understand that by negotiating appropriately designed cumulation-based RoOs in these FTAs, India can accelerate its integration with GVCs and overcome the limitation of staying out of the Regional Comprehensive Economic Partnership.

 

Finally, it needs to be recognised that almost all major existing and potential export markets — the US, UK, EU, Australia and Asean — are in the process of developing their own versions of the Carbon Border Adjustment Mechanism (CBAM). So, it will be more pragmatic for India to hasten its transition to a domestic carbon pricing market mechanism rather than hope for concessions and flexibilities in FTAs. 

 

India, thus, has a huge reform agenda ahead and there is no time to lose.