#302 A Fine Imbalance

China as a Market Failure, India's GDP Results, Trump's BBB, and Assam's Gun License Policy Change.

Global Policy Watch #1: China is an International Market Failure

Insights on global issues relevant to India

—Pranay Kotasthane

Market Failure is a pivotal concept in public policy. The basic intuition here is that governments should consider intervening only when the market fails. There are four canonical ways the market fails: market concentration, information asymmetry, externalities, and public goods. If and only if there is evidence pointing to these four failures does government intervention make sense. Once the root cause is identified, a mapping of government interventions to specific market failures comes to the rescue: finance recipients if the market failure is a positive externality, regulate if the market failure is information asymmetry or market concentration, and so on.

This established framework is the bread and butter of domestic public policy analysis, but is seldom used in the international realm, and for good reasons. Countries have vastly different regulatory frameworks, labour standards, environmental rules, and levels of government involvement in the economy. Every sovereign nation-state is within its rights to decide its trade-offs and come up with its own policy mix. Thus, what we would otherwise call market failures are inherent to such a structure. For example, a country can choose to excel in a highly polluting industry. Even though such an act would produce negative externalities to the region, it is not framed as such because sovereignty is considered the higher value. This is a good principle to follow; we wouldn’t want other countries lecturing India on the developmental choices it makes. Hence, it’s a good idea not to see these issues through the lens of market failures, except if there’s a situation in which some actor’s domestic actions produce market failures with impunity at a scale that severely impacts several countries at once.

China is one such exception. I find it amusing that China claims actions against it are anti-market, while it’s the one upholding the principles of free trade. In reality, China's use of subsidies, currency manipulation, unfair trade practices, and many other policy instruments creates a lopsided relationship with the world that qualifies as a market failure. Here’s how.

Consider the example of China’s rare earths industrial policies to demonstrate this point. Until recently, China flooded the world with low-cost rare earths driven by heavy subsidies and deliberate currency manipulation. And now, having attained market power, it is attempting to use export restrictions on these metals as a form of geopolitical leverage. Both these situations demonstrate multiple market failures.

First, take the case when China was merrily flooding the world with rare earths. Here are the market failures that the situation produced:

1. Market Concentration: Efficient allocation means that production of rare earths should occur where it's genuinely most cost-effective. However, artificially cheap Chinese rare earths drove out efficient producers elsewhere. Market inefficiency increased as global production concentrated in China, not because China had any unique comparative advantage, but because of its massive subsidies and currency manipulation. This happened even as the efficient producers in other countries exited the market. The result was that global rare earth production became concentrated in potentially less efficient locations.

2. Information Asymmetry and Negative Externalities: An efficient market means one where prices signal actual scarcity and production costs. However, China’s policies of undercutting global rare earth prices concealed the real production costs. This created inefficiency in the sense that consumers overconsumed rare earths; companies in other countries couldn’t assess their comparative advantage due to the distorted prices; there was reduced innovation in alternative materials and recycling; and investment decisions were made based on false price signals. Job losses in many countries and strategic dependency risks were other costs that weren’t factored into transactions.

Now, consider the current case where China is implementing export restrictions after having used the previous market failures to its advantage. This, too, produces market failures.

1. Market Concentration: Efficient allocation means resources should flow to consumers who value them most. However, China's dominance enables it to restrict supply below efficient levels, thereby creating artificial scarcity. This creates inefficiency, as high-value uses, such as high-tech or clean energy, can't access minerals, while lower-value uses continue because the supply is politically controlled.

2. Information Asymmetry and Negative Externalities: Companies can't predict supply availability, so they can't make optimal investment decisions. Companies will have to over-invest in expensive backup suppliers and stockpiles. The fear of new investment commitments being derailed by a resumption of Chinese oversupply will cast a shadow on future projects.

Whether it’s rare earths, solar panels, or pharmaceutical APIs, the same story plays out over and over again. Multiple market failures reinforce each other, allowing China to exploit the global trading system to its advantage.

While many countries have woken up to the threat from China, they are responding individually with ineffective instruments, including tariffs, export bans, and increased scrutiny of investments. That’s where framing China’s conduct as an international market failure can help bring countries together and force China to take corrective action. The current situation is not the result of a US-China trade war, but a direct consequence of China’s use of the global economic system to its benefit at the expense of others. Without this lens, China will continue to portray itself as the champion of a system it dismantled.

---

India Policy Watch: Transient Good News?

Insights on current policy issues in India

—RSJ

The GDP numbers for Q4 FY25 came in on Friday this week with a better-than-expected growth print at 7.4 per cent y-o-y. This was driven by strong growth in construction (10.8 per cent y-o-y) and a meaningful uptick in Gross Fixed Capital Formation (GFCF) at 9.4 per cent y-o-y, aided by a jump in government capex that was otherwise weak through FY25. The upside on growth was a surprise, and many analysts expect this trend to continue into FY26, with a possibility of growth upgrades. To be sure, H1 FY26 will benefit from a weak base of FY25, but that might not hold for the full year. We will need to see how Q1 FY26 goes before believing the hype about the resilience of the Indian economy. There are three reasons for the caution.

First, the impact of tariffs and global trade uncertainty on India remains unclear. There will be short-term pain before the proposed trade agreements with the US and EU bring relief. Nobody is sure though and Trump’s recent announcement of erecting a tariff fence around domestic metals production gives no assurance that his administration has been chastened by the recent judgments on tariffs by federal courts. Trump has announced an increase in tariffs on steel and aluminium from 25 per cent to 50 per cent from June 4. Trump’s volatility on tariffs is already taking a toll. US goods imports fell by almost 20 per cent in April over the previous month, amidst confusion among importers on tariff rates. A broader US slowdown and the resulting uncertainty from the trade war will not only impact goods exporters in India but also the Indian IT services exporters for whom the US remains the biggest market. For them, this comes on top of the risk of programming jobs getting automated at a fast clip as LLMs are getting smarter in coding and eliminating entry-level programming jobs. These headwinds might only get stronger through FY26 and will weigh on GDP numbers.

Second, despite the 50 bps rate cut in Q4 FY25 by the central bank, there has not been a meaningful pick-up in credit growth. Some of this is a transmission issue, but the early signs on credit bureau enquiries and other high-frequency indicators on credit uptake don’t point to any uptick in consumer demand because of lower credit. There is another 50 bps cut expected in the next two quarters, which might move the needle, but I’m a tad sceptical because I’m not sure of the underlying demand in the economy. The Q4 FY25 results and commentary of listed entities pointed to a weak demand in the economy, couched in the language of green shoots and an imminent recovery. I expect continued monetary easing and a more benign approach to fiscal consolidation during FY26 to prop up growth. But I’m not sure if that will be enough.

Lastly, there is no signal that the private capex cycle has started after years of waiting on the sidelines. Despite all the platitudes served up by them in conferences and summits, Indian industry, especially manufacturing, has barely put its money where its mouth is. Government capex, which has done the bulk of the heavy lifting since COVID-19 times, will remain somewhat muted in FY26, as the ₹1 trillion income tax break offered in the budget was supported by a cut in infrastructure budget. The additional geopolitical risk that has now come into the calculus of investing in India will also weigh negatively, especially if there’s another border flare-up.

So, despite the positive surprise of Q4 FY25 numbers, there’s no immediate trigger to change the muted outlook for FY26. Perhaps a speedier conclusion to the bilateral trade deals, a lower-than-expected crude oil price, and some collateral benefits from the US-China trade war might change this. We will have to wait and watch.

---

PolicyWTF: (H)Arming Citizens

This section looks at egregious public policies

— RSJ

In the past few years, I have been impressed with the MP and Assam governments in their ability to make outrageous statements and then follow up with loony policy ideas. What MP and Assam think(?) today, India thinks tomorrow.

Himanta Biswa Sharma, the CM of Assam, who has tirelessly led Assam to this enviable position through his words and actions, shows no sign of taking a break. This week, his government announced a special scheme to provide arms licences to “indigenous” people living in “vulnerable and remote areas” and those along the border with Bangladesh to help them protect themselves. The scheme is expected to come into effect within 24 hours of notification. To make the reason for this scheme clearer, Mr. Sarma held a press conference. As the Hindustan Times reports:

The decision, taken at a state cabinet meeting, will be applicable in districts like Dhubri, Nagaon, Morigaon, Barpeta, South Salmara and Goalpara, Sarma told reporters. Muslims are in majority in 11 of the 35 districts in Assam, of which four share borders with Bangladesh.

“It’s a very important and sensitive decision. Indigenous people in some areas have been feeling insecure, especially in the wake of recent developments in Bangladesh (where Hindus were targeted) ... In this backdrop, the cabinet decided that indigenous people in such vulnerable areas will be given arms licence,” he said.

“The government will be lenient in giving licences to eligible people, who have to be original inhabitants and must belong to the indigenous community living in vulnerable and remote areas of the state,” Sarma said, clarifying the government will not help buy arms, but only give licence to the eligible people.

This is the kind of fire we have played with throughout the 1970s and 80s, with disastrous consequences. There is no legal definition of ‘indigenous people’ or of ‘vulnerable areas’ in Assam, so it will be up to the discretion of the state to decide on who to give these licenses. The bureaucracy will sit in judgment on who gets a license. This is both wrong and insane on so many levels. The state has to ensure the protection of its citizens by identifying and nullifying the threats to society through the law enforcement machinery at its disposal. It can’t outsource it away to ‘chosen’ citizens by arming them and then letting them decide who they might consider as threats. This creates a society where one set of citizens has been given the privilege to inflict violence on another without any safeguards. To compare it with the US second amendment is stupidity. That right is available for all US citizens, and the state doesn’t decide who should be given a gun license. Plus, the gun culture that the abuse of the Second Amendment has engendered isn’t something we should aspire to emulate. This is just an invitation to vigilantism and a move to polarise the state in the run-up to elections, which is about six months away. Left unchecked, this is a recipe for disaster.

---

Global Policy Watch #2: Big Beautiful Bull (err Bill)

Global policy issues relevant for India

—RSJ

In more than one edition in the past two months, I have mentioned that an eventual course of action Trump 2.0 might take to balance the trade deficit with the world will be to tax foreigners holding US financial assets.

From edition #289:

“Countries can trade in either goods and services or financial assets. The current account balance is the difference between exports and imports of goods and services, while the financial account balance is the net trade that happens on things like stocks and bonds. For every single transaction of a product or service between two countries, there is a corresponding financial transaction that happens to square off that trade. This leads to the other critical equation:

Financial account balance = current account balance

It is tempting to think that by placing restrictions on foreign capital inflow that buys up US assets, one can increase the financial account balance and thereby improve the current account. But then this is not a mere mathematical equation that will work this way. Once again the empirical evidence would suggest such control on capitalinflows don’t necessarily lead to GDP growth. In fact, such measures, say if the US were to tax capital flowing in to keep the Dollar weak, will lead to significant disruptions in the global financial market and a possible move away from the Dollar as a reserve currency before one can figure out if it has helped the US economy.”

From edition #297:

“….the US current account deficits continue to remain high because it can sell its treasuries to other central banks looking to park their dollars in safe assets instead of doing any break work to reduce the deficit. It is a system that works well politically for everyone. Exporting countries don’t need to bring the surplus dollars home and the US can continue to print its way out of any trouble. The easy access to holding US financial assets is what supports the trade deficit through an overvalued dollar and a low-yielding 10-year T-bill. This has meant that over two-thirds of the global trade is conducted through dollars, and a similar share of global securities are issued in them. This gives the US enormous leverage over the global financial system and in a way a control over other central banks because it remains the sole supplier of the dollar. An easing or tightening by the US Fed will need to be mirrored by other central banks to support their currencies.”

Well, we have reached there. Somewhere in the thousand-page ‘big, beautiful bill’ (BBB) that was passed by the House last week is section 899, as many have discovered last week. This allows the US to increase the federal income tax and withholding tax on investors that are from a “discriminatory country” which is any country that imposes unfair foreign taxes as determined by the US Treasury department. At a tactical level, this seems to be a pre-emptive move in US trade negotiations with the EU (and Canada), which are harbouring ideas of a digital services tax on US Big Tech. But in the long run this is a move to tax capital assets held by foreign investors, to discourage foreign investment, raise borrowing costs and to accelerate the decline in the USD. It is a move to raise barriers for foreigners to access US capital markets. It is a remarkable clause, especially in a bill that will raise the US deficit by another $ 3tn over the next decade and which will need global investors to buy US treasuries to fund that debt. Capital is already fleeing the US markets since the ‘liberation day’, with bond markets voting with their feet on Trump’s shenanigans. The US is working hard to dismantle its status as a safe haven for investors. Good luck with it.

---

HomeWork

Reading and listening recommendations on public policy matters

1. [Paper] This paper finds evidence that India’s inability to let firms dissolve in a dignified, lawful manner is a major reason for its poor industrial performance. Brilliantly titled No Country for Dying Firms: Evidence from India, the authors find that:

   “… reducing exit barriers is at least as important as reducing entry barriers. Reducing exit barriers targets firms that should exit, but don’t because of high exit costs, namely low productivity firms that face low scrap value/high firing costs. High exit costs lock productive resources with low-productivity firms, dragging down overall productivity. In addition, since exit costs also act as entry barriers, they deter entry, further slowing down growth… Spending the same amount on reducing exit barriers raises value added by more, productivity by much more, though it raises employment by less.”

2. [Podcast] Here’s a fun Puliyabaazi ft. Aditya Ramanathan on the military platform of choice in ancient and medieval India—elephants.

3. [Podcast] This episode of the Dwarkesh Podcast featuring Victor Shih is a must-listen for understanding contemporary Chinese politics.

4. [Post] It’s great news that 15 foreign universities will open their Indian campuses soon. We had a post in 2023 on the politics that prevented this from happening earlier.

---