What’s happening to India’s growth drivers: Exports?

By Sajjid Z Chinoy and Jahangir Aziz

jpmorgan.com:  With India’s current account deficit (CAD) reaching unsustainable proportions and the real exchange rate experiencing a sharp depreciation over the last year, one of the critical policy debates in the country currently is whether India can take advantage of the currency weakness and export its way out of the problem. Our analysis believes not.

To be sure, exports have become India’s latest, but unappreciated, growth driver underpinned by a dramatic shift in geographical and product composition over the last decade. However, we find that India’s changing export basket is far more responsive to changes in external demand rather than changes in the real exchange rate. Whether the CAD narrows in coming months will therefore depend crucially on the growth prospects of emerging markets (EMs) — to which the bulk of India’s exports now go — rather than how the exchange rate evolves.

The prodigal son

In many ways, India’s export story is like the prodigal son. Far from being recognized as India’s newest growth driver, strong export growth is taken for granted, and only comes under the spotlight when growth moderates.

For starters, India’s export growth bounced up remarkably sharply after the 2008 crisis in part because of the groundwork that had been laid before the crisis—the move to newer products and destinations. Yet, instead of acknowledging this, several analysts fundamentally questioned the veracity of the data itself -- something that was found to be a storm in a tea-cup (see, “India’s sizzling export growth -- debunking the conspiracy theories,” MorganMarkets, August 19, 2011).

Once that hurdle was crossed, it became fashionable to blame exports for all the economy’s current ills. At the first signs of a slowdown, the first line of defense of many was to blame the global economy, implicitly suggesting that exports were at the root of the growth slowdown. More recently, the burgeoning current account deficit—and its role in keeping the rupee weak—is also, in part, laid on the doorsteps of slowing export growth—an issue that we address below.

Exports consistently outpace GDP growth

In contrast to the common presumption that domestic consumption is the main driver of growth in India, it is important to recognize that export growth has jumped over the last decade, and consistently outpaced GDP growth, as well as that of consumption and investment. To be sure, private consumption is undoubtedly still the largest share of GDP, but its share has been on a secular decline over the last two decades. Investment growth experienced a surge in the mid-2000s but has slumped sharply over the last few years.

In contrast, exports have experienced consistently strong growth over the last two decades. To be sure, they started off a small base. Exports’ share of GDP was less than 6% in 1990, at the time of India’s balance of payments crisis that triggered the first wave of trade reforms. By the end of that decade, that orientation toward a more open economy had meant its share had doubled to 12% of GDP. That much is well known.

What is less appreciated is that the last decade has seen another doubling of this share, with exports now estimated to be more than 25% of GDP at the end of FY12 – a quantum jump in less than two decades. The RBI estimates that 60 to 65% of manufacturing output is exported, consistent with the fact that exports have begun to meaningfully influence variables like IP and inflation.

Manufacturing exports lead post-Lehman rebound

Of more recent relevance is the fact that exports bounced back sharply since the global financial crisis and have been a key driver of overall growth since then. Despite the fact that service exports have slowed since the crisis—unsurprising since they are largely concentrated in the US and Euro area—manufacturing exports have surged over the last two years, more than offsetting the moderation in services. As a consequence, the share of exports in GDP has risen to 25% in 2011 from 22% before the Lehman crisis—a 3%-pt of GDP increase in three years, despite the fact that the period in question included the Lehman years

Furthermore the outlook is encouraging. Exports fell in the second half of 2011 as global uncertainty rose in the wake of turbulence in Europe. However, the worst seems to be over. New export orders within the PMI—which are a reliable leading indicator of manufacturing exports—bottomed in 3Q11, and have risen over the last six months, suggesting that exports are likely to accelerate further, barring a sharp global shock.

Don’t blame exports for CAD woes…

Contrary to some perceptions, exports are not at the heart of the burgeoning CAD. The latter surged from 7.5% of GDP in FY11 to 10.2% of GDP in FY12. However, during that period, exports actually rose to 16.3% of GDP from 14.5% the year before. Instead, the culprit was exclusively imports (particularly gold), which surged 4%-pts of GDP to 26.5% of GDP, more than offsetting the increase in export growth to worsen the CAD.

From Britain to Beijing...

So what’s driving this strong export buoyancy? One of the keys is India’s increasing geographical diversity. A decade ago, exports were far more concentrated with 52% of the merchandise basket going to the key developed markets (US, Europe, Japan). This resulted in both slower growth and less geographical diversity, causing exports to ebb and flow with the fortunes of the developed world.

A decade later, the situation is radically different—exports are far more geographically hedged. The majority of merchandise exports now go to various emerging markets (67%), with the DMs accounting for less than a third of the share. As a result, India is now far more integrated into the regional supply chain than a decade ago and China has become an increasingly important export destination. This largely reflects a changing product composition of exports – an issue addressed next – that has allowed exporters to access and compete in new markets.

...software to manufacturing

The word “exports” in the Indian context always conjured up images of a booming software industry. Yet, this is a notion based on the middle of last decade. Instead, the compositional dynamics of India’s export story are changing post-Lehman crisis, in the wake of sub-trend growth in the US and Euro area (where the bulk of software exports are directed) and much faster growth in EMs, where the majority of manufacturing exports are now directed.

As a result, the growth of manufacturing exports has accelerated sharply since the global financial crisis whereas that of service exports has predictably moderated. To be sure the latter is still growing at an average rate of 15% (in value terms) over the last three years, but this is a step down from the 25% growth that characterized this sector from the beginning of the last decade until the Lehman crisis.

Conversely, manufacturing export growth has upshifted to almost 20% (in value terms) post-crisis from the 14% growth witnessed in the pre-Lehman era. As a result, despite the attention on software exports, currently they constitute only about a sixth of India’s gross exports, whereas the unheralded merchandise sector makes up two-thirds and therefore has a much greater impact on India’s CAD.

...and T-shirts to cars

Within the manufacturing sector, too, there has been a seismic shift over the last decade. India’s traditional, labor-intensive, small-scale-industry-dominated exports such as leather and textiles have lost significant share within the export basket. Textiles have taken a particularly big hit, losing about 20%-pts of share in the basket, while leather has been less severely hit.

These have been replaced by the higher tech, more mechanized, more differentiated engineering goods (automobiles, auto parts, capital goods) and chemical products, which together constitute almost 60% of the manufacturing goods (ex. oil) basket. The reason this distinction is important is that the manner in which these new-age manufacturing exports respond to changes in the global environment is very different from that of India’s traditional exports.

Will the INR depreciation boost exports?

One of the most important policy dilemmas currently facing authorities is how to rein in India’s surging CAD. The deficit has reached an unsustainable 4% of GDP this fiscal year, putting severe pressure on the currency. In the wake of this, some analysts are advocating draconian measures on the import front. Others believe the sharp depreciation will materially boost exports and that India can export its way out of the problem. Which is it? Is India’s new export basket more price sensitive or demand sensitive?

We conducted a dynamic OLS regression analysis to systematically analyze the price and income elasticity of India’s exports, both at the aggregate level and by sub-sector, extending the analysis in the Special Report “India: more open than you think,” Oct 14, 2010 (details of the methodology and results are available on request).

The results are striking. At the aggregate level, India’s exports are significantly more responsive to changes in external demand than to price. The coefficient of external demand suggests that a 1% increase in external demand would increase export volumes by 4.4%. In contrast, the price elasticity is neither statistically nor economically significant. A 1% increase in India’s REER would reduce export volume by 0.7%, but this estimate is not statistically significant.

This flies in the face of conventional wisdom that India’s exports are highly responsive to changes in relative prices. These results are not inconsistent with the events over the last year. Even though the price elasticity is small, the sharp depreciation of the real exchange over the last year (more than 10%), should have provided a boost for export growth. Instead, export growth has moderated from the previous year despite the fact that growth in partner countries has moderated, but not collapsed. This is consistent with a high income and low price elasticity, with the impact of the former swamping the latter over the last year.

Equally importantly, it underscores how vulnerable India’s exports are to changes in external demand. A 1% reduction in external demand would reduce exports by almost 5% and thereby reduce GDP growth by more than 1%-pt -- not a phenomenon that markets in India are historically used to.

Export composition the key

The key to a high – and rising – demand elasticity over the last decade (the elasticity in the latest sub-period (2005-10) is twice that of 1996-2000 period) is the evolving composition of India’s export basket. Specifically, we find that the services sector has a higher demand elasticity than the manufacturing basket and primary products. This is not surprising given that the bulk of India’s service exports are software and BPO services, which can be deemed to be relatively discretionary in consumption.

Interestingly, a similar compositional impact is felt in the manufacturing export basket. The newer, higher value-added exports (engineering goods, pharmaceuticals) are far more demand elastic than the traditional leather, textiles, gems, and jewelry exports. As the relative share of these new-age manufacturing exports and service exports has increased in India’s export basket over time, so has the aggregate demand elasticity. Interestingly, none of the main subsectors has an economically or statistically significant price elasticity.

Putting it altogether

India’s export sector has become an important engine of growth, particularly in the post-Lehman period, underpinned by a dramatic shift in the composition of goods and services being exported over the last decade. Of late, however, the policy debate has turned to whether India can export itself out of its current account deficit dilemma, in the wake of the sharp real depreciation of the currency over the last year.

We find that this is unlikely to happen. Our analysts suggest that India’s exports are increasingly elastic to external demand and relatively unresponsive to movements in the REER. As such, whether EM growth picks up in 2012 or is buffeted by another shock emanating from Europe will have a far greater bearing on India’s export growth — and thereby overall growth prospects — than will movements in the currency.