One of the objectives of the Budget would be to achieve a much lower trade deficit in 2012 than the massive one this year. The 2012 Budget to be presented in parliament on November 21 has this additional challenge.
Fiscal policy has to be used to reduce the trade deficit that is rising to massive proportions. In the first eight months of the year it had reached nearly US$ 6 billion. At the end of the year it is likely to reach US$ 9 billion.
To reduce the trade gap to manageable proportions, sound fiscal policies are required. Fiscal operations should try to reduce import expenditure, while stimulating exports. Most of the reduction in the trade deficit would have to come from the reduction of imports. Tariffs are one means of doing it. The reduction in aggregate consumption is the other.
Massive trade deficit
In the first eight months of this year export earnings increased by 28.6 per cent to US$ 6,966 million, while expenditure on imports increased by as much as 50.6 per cent to US$ 12,926 million. As a result, the trade deficit increased to US$ 5,960 million for the first eight months. A likely trade deficit of around US $ 9 billion at the end of the year is an unsustainable gap that must be reduced next year, if the country is to avert a crisis situation in external finances. No doubt the containment of the trade deficit would be as much in the minds of the Finance Ministry preparing the Budget as containing the fiscal deficit. In fact the containment of the fiscal deficit would assist in containing the trade gap.
Fiscal policy and trade deficit
The relationship between the Budget and the trade deficit is not readily recognized. Most persons would view the two without being mindful of the connection between them. The proposals and outcome of a budget have far reaching implications for the country's trade balance.
At a macroeconomic level, the budget being the centre piece of the government's economic policies has a pervasive impact on the economy's aggregate economic performance and the production and consumption of goods and services. Aggregate production and consumption influence and determine the exports and imports of a country. Budgetary policies affect the country's production of goods and services and the costs of production. The increase of exportable goods as well as the production of imported goods and their substitutes would increase export earnings or reduce imports. Aggregate expenditure affects imports as most expenditure has import content.
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It is for these reasons that Sarath Rajapatirana, a former Economic Advisor of the World Bank and leader of World Bank missions to several Asian and Latin American countries, made the perceptive observation that "trade imbalances are best seen as part of a macroeconomic imbalance, where excess demand spills over to the trade balance." Therefore he pointed out that "one cannot address one imbalance without considering the others and that addressing a trade imbalance through trade restrictions cannot work as it does not address the excess demand in the goods market that has caused it in the first place."
The budget proposals could also affect specific sectors as well. Import taxes on certain items could discourage imports. They could also change the profitability of production of specific goods and services and thereby increase or decrease exports and imports. A large fiscal deficit could increase inflation and if the exchange rate is not depreciated to take into account the rate of inflation, exports would be discouraged and imports made more attractive, thereby increasing the trade deficit. Therefore the impact of the budget on exports and imports is diverse and all-encompassing.
Fiscal policy
Fiscal policy has been frequently used by governments to reduce imports, encourage import substitution and assist exports. With the current widening trade gap fiscal policies could be used to reduce imports and either increase exports or increase substitution of some key import items. Therefore it is likely that the budget would propose measures to reduce import expenditure and stimulate export earnings. The recent imposition of higher taxes on cigarettes and foreign liquor are primarily taxation measures, but its effect on the import of foreign liquor could reduce import expenditure.
Fiscal policy could assist in containing the trade deficit in several ways. This is especially so as the government is averse to the adjustment of the exchange rate. The depreciation of the currency to contain imports and encourage exports is generally considered the best mechanism for adjusting the trade balance. This, however, does not find favour in the government.
Another means of adjustment are quantitative controls of imports. This is the system best known as quotas and import controls. The WTO, IMF and international bodies overseeing international trading system no longer permit such controls. The system of multiple exchange rates that prevailed from 1965 to 1977 is also not permitted. In this background, fiscal policy is the means of containing the trade gap.
Measures in the budget to decrease consumption are a means of containing imports through an income adjustment. When disposable incomes are reduced the propensity to import is reduced.
Another means of restraining consumption is to increase tariffs on imports. This is often resorted to by increasing tariffs on selective imports. The recent instance when the government reduced tariffs on motor vehicles, electronic items and some other consumer durables witnessed a surge in imports that is one of the reasons for the current increase in imports. A reversal of such policy would restrain imports. The Budget 2012 is most likely to introduce higher tariffs on imports of selected items.
As the problem of the trade imbalance is serious there may be a need to go beyond the restriction of consumer durables to the import of food items as well. There is an indication that tariffs on food items such as wheat, sugar and milk would be increased. The argument adduced for such a revision of tariffs upwards will not be the need to contain the trade deficit, as suggested here, but that it is in the interests of domestic agricultural production.
The rationale for such increases in tariffs on food imports is that of import substitution. It is argued that higher tariffs would increase domestic prices that would be an incentive for farmers to increase production. This is partially correct. However whether it would achieve such an objective is uncertain as there are very many other constrains restricting increases in agricultural productivity and production. Higher tariffs must be accompanied by improvements in irrigation, higher yielding seeds and planting materials, good research and extension services, credit and improved marketing channels. Increasing import duties alone will not increase food production.
Increased tariffs are likely to reduce imports of food that now absorbs around 10 percent of import expenditure. Higher tariffs would increase prices and the cost of living and have an inflationary impact. Increase in tariffs of other consumer imports are also likely. This would include consumer durables, perhaps motor cars and articles of consumption that are often considered luxury items. A general increase in tariffs is likely to contain imports.
Petroleum imports
The highest import expenditure increase this year has been on petroleum. Petroleum imports increased by 51 percent in the first eight months compared to the same period last year and cost US$ 2980 million. It constituted as much as 24 percent of the import bill. This is due to an increase in consumption as well as increase in prices. The higher increase in consumption this year has been due to increased thermal generation of electricity owing to lesser generation of hydro electricity due to reduced rainfall. Besides this, there has been a trend of increased petroleum use for transportation.
The reduction in petroleum imports could make a serious curtailment in import expenditure. How could this be achieved?
Increased prices for petroleum products could curtail consumption but increase the general level of prices as petroleum prices would increase prices of most commodities due to increased transportation and production costs. It would also increase electricity tariffs. Therefore this may not be an acceptable policy option.
One of the ways by which oil consumption could be curtailed is by reducing the allocations for transport in public expenditure. If this policy option is implemented by government agencies, import expenditure on oil could be curtailed. Measures to conserve petroleum use are needed to reduce import expenditure.
Conclusion
The adverse trade balance is likely to be an important consideration in the Budget proposals. Import tariffs are likely to be increased on many categories of imports. It is prudent to ensure that the tariffs on basic consumer items are not increased. However, both revenue considerations and need to curtail import expenditure may result in increases in tariffs of such items. In which case there would be an increase in domestic prices.
Reductions in consumption of many imported items are needed to make a reduction in import expenditure to reduce the trade deficit and ease the balance of payments next year.
The government is committed to reduce the fiscal deficit to 6.2 percent of GDP in 2012. It expects to achieve this while maintaining an 8 percent economic growth and keeping the annual rate of inflation between 6 and 7 percent. The achievement of these three objectives simultaneously is indeed a challenging task, especially in the context of uncertain global developments. However these are objectives that must be pursued through fiscal discipline.
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