Finance Minister Nirmala Sitharaman said on Monday that India-U.S. trade talks have reached a “plateau” and further concessions from either side might be difficult. To begin with, those celebrating India extracting a great trade deal from the U.S. miss the point. While a deal with some relaxations may be better than no deal, we have to compare the situation against the status quo, i.e., what it was before the Trump tariff was imposed. This piece attempts to discuss the importance of the trade surplus that India runs with the U.S. in this context.
What makes the situation difficult is that India runs a trade deficit with China (red bars in Chart 1) but a surplus with the U.S. (blue bars in Chart 1). And it is not just that. India buys goods from China that are not easily substitutable, at least not in the short run; i.e., it is a structural deficit that is not easy to reverse. On the other hand, the heavy tariff on Indian goods that Donald Trump has threatened to impose, and the development of artificial intelligence (AI), could reverse its surplus with the U.S. Combine these two factors, and India faces a serious problem on the trade front.
India is caught between the devil and the deep blue sea.
Forex market and the rupee’s value
Like many other markets, the price of a currency is determined by its demand and supply. In India’s case, let us consider the value of the Indian rupee (INR). As a proxy for a global currency, we take the U.S. dollar. How many rupees a dollar can buy is India’s exchange rate vis-à-vis the U.S. dollar. A rise in the number of rupees a dollar can buy means a rise in the value (price) of the dollar and a fall in the value of the rupee.
India’s demand for dollars consists of its imports and capital outflows (outward Foreign Direct Investment (FDI) + Foreign Portfolio Investment (FPI)). A rise in the price of the U.S. dollar (a depreciation of the INR) means imports become more expensive for Indians because they have to shell out more INR to buy the same goods they were buying earlier. So, it is often assumed that demand for dollars falls with a rise in the price of the dollar. The supply of dollars to India comes from exporters, capital inflows (inward FDI + FPI), transfers, Net Factor Income from Abroad (NFIA), and external borrowing and deposits. In contrast to imports, exports are assumed to vary positively with the price of the dollar. If a dollar can buy more rupees, then the cost of employing a computer coder sitting in India becomes cheaper for an American firm. Once you bring the demand and supply together (in Diagram 1 (a)), the equilibrium value of the rupee is determined.
A caveat is in order. This is a simplified representation of reality. Firstly, India’s exchange rate is not fully market-determined. The central bank manages the value of the rupee by intervening in the market to keep the exchange rate within a range of its preference (between the levels in Diagram 1). India has what is called a managed float system. How does the central bank intervene? If the demand for dollars outpaces its supply by so much that the rupee threatens to depreciate below the level preferable to the central bank, it releases forex to the markets (thereby inflating the supply of forex available) and keeps the rupee within the range. It adds to its reserves if the opposite happens, i.e., the rupee appreciates outside that range.
Secondly, the demand and the supply curves are not as neat as they are presented here. For example, beyond a certain range of depreciation of the rupee, capital outflows (for fear of loss in its dollar value) may far outpace the fall in imports, making the demand curve vary positively with the exchange rate, i.e., a C-shaped demand curve. But we leave those complications aside for this piece.
Trump tariff and the Iran crisis
Diagram 1 (b) is a schematic representation of the state that India is/likely to be in. Faced with a rising dollar price of crude imports, the demand curve for India would go up significantly. This threatens a depreciation of the rupee (which is what has worried India so much). Since this threatens to push the exchange rate beyond its range, the central bank would have to run down its reserves to manage the rupee’s value, as it has done in the last two years.
The role of a Trump tariff (added to the potential loss of exports that AI may bring in) needs to be seen in this context. Such a tariff, if implemented, will push the supply curve of dollars (due to a fall in exports to the U.S.) to the left and add to India’s current woes on the external front. The extent of depreciation resulting from this is far beyond what India is facing currently. And to maintain prevent the currency from depreciating beyond the upper bound may require a significant loss of reserves, an intervention which may set off a vicious cycle of capital outflow and depreciation.
Chart 2 plots these demand and supply values for the last nine quarters to show that the demand for dollars has outpaced the supply for four out of the last nine quarters. And there has been a sharp rise in demand in the aftermath of the closure of the Strait of Hormuz.
Criticality of the U.S. markets
Let us look at the trade surplus that India has with the U.S., which is the bone of contention for President Trump. If we divide the trade surplus into goods and services, we get a disaggregated picture of the current account surplus that India runs with the U.S. (see Chart 3). India’s surplus in goods (Chart 3(a)) is much higher than it runs in services (Chart 3(b)) vis-a-vis the U.S.
The aim of Trump tariff is to reverse this goods balance in favour of the U.S. to the extent possible. If the U.S. continues to arm-twist India, it makes better economic sense for us to gradually diversify away from the U.S. economy. What will be lost in the U.S. market could, at least potentially, be compensated within the Global South provided the right trade and industrial policy architecture is in place.
India should, accordingly, treat the Trump tariff as a wake-up call and use this opportunity to focus on export growth by diversifying the exportable product mix and regional development.
(The authors are a part of the DevMac (Development Macroeconomics) network, which seeks pluralism in Economics)