India Should Resist Import Substitution: Sajjid Z. Chinoy, Head of Asia Economics, J.P. Morgan

The epoch of globalisation was defined by an overarching focus on efficiency, cost-minimisation and “just-in-time” manufacturing. Global supply chains dramatically proliferated around the world and “specialisation and exchange” became the organising principle of global production—a thought that would have mightily pleased Adam Smith and David Ricardo. Trade boomed, both across and within industries. A quintessential example of that is the modern iPhone, which comprises almost 500 parts sourced across 43 countries and 6 continents. This perhaps represents the high noon of comparative advantage.

But this epoch is now under pressure. Two sets of concerns are rising. First, what the litany of recent shocks has revealed (Covid, Russia-Ukraine conflict, West Asia conflict) is that countries must be wary of excessive import concentration risk. Countries that are too dependent on any one country/region for critical inputs stand exposed during shocks. Asia’s excessive dependence on the Strait of Hormuz for energy is a case in point. Second, trade is being increasingly weaponised as a multilateral, rules-based order is quickly replaced with extractive bilateral mercantilism.

So how should India respond to this changing global backdrop? There are both dos and don’ts.

India must start by systematically identifying chokepoints and vulnerabilities. It is well known now that 90% of India’s liquefied petroleum gas (LPG) flowed through the Strait of Hormuz and almost 50% of India’s liquefied natural gas (LNG) came from Qatar. But other chokepoints also exist. About 70% of India’s active pharmaceutical ingredients (APIs) are sourced from China, with some estimates that this ratio rises to almost 90% for antibiotics. Meanwhile, almost all of India’s polysilicon (used for solar panels) is imported from China and more than 90% of India’s lithium-ion batteries are imported from China.

All this suggests too much concentration risk, leaving India vulnerable to critical inputs during shocks and crises. We must pursue a multi-pronged approach to mitigate these risks by:

Building physical buffers for existential commodities: 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 US-Iran conflict. On its part, China has strategically built stockpiles of crude and 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.

Diversifying where we can: Buffers are important when there are global shortages. But to protect against import concentration from any one country, diversifying imports across multiple economies is crucial. We should have always been buying more LNG from the US and more LPG from Australia, for instance.

Hedging price risk where possible: 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 protect against large swings in oil prices – and the uncertainty they engender on inflation, fiscal and the current account?

Allowing foreign direct investment (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 an encouraging start, but more needs to be done.

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.

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 higher 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 several reasons. First, risk mitigation does not warrant recreating entire supply chains at home. This will be a 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% for the next two decades—and 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. Policymakers must be commended for pushing ahead with a slew of Free Trade Agreements over the last two years. We must now turn our focus to mega-regionals like CPTPP (Comprehensive and Progressive Agreement for Trans-Pacific Partnership). 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.

Globally, the calm seas of the past few decades have been replaced by an enduring storm. We need to ensure our external trade architecture is more resilient and shock-absorbent 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 while minimising disruption. The task is both daunting and urgent, but, then again, these are not ordinary times.

Views are personal.