How is India waging an economic battle with China despite the widening trade deficit?

If you walk into a toy store in India, you might not only walk out with a child's new favorite toy, but you might also get a glimpse into how the country is waging a battle to improve its economic relationship with its powerful neighbor, China.

Six years ago, in an attempt to support local manufacturing and prevent low-quality toys from entering the market, India raised customs duties on imported toys from 20 percent to 60 percent, and later to 70 percent.

The decision angered retailers, who said local companies would never be able to compete with products manufactured abroad, but the combination of high customs duties and quality control standards has proven effective.

India's toy imports fell by about a third, from nearly $300 million in 2020 to $100 million this year, while exports rose from about $129 million to $200 million during the same period.

The country was also able to significantly reduce its dependence on China, after Chinese products occupied 70 percent of the local toy market.

The gaming sector stands out as an exception to India's unsuccessful attempts to rebalance its increasingly imbalanced trade relationship with its larger neighbour, a relationship that some experts say has become among the most unequal in the world.

Even with the collapse of diplomatic relations between the two countries almost completely following the clashes in the Galwan Valley in 2020, and Delhi announcing a series of anti-dumping duties and banning Chinese applications such as TikTok, the Indian trade deficit with Beijing continued to widen, from $44 billion in 2020 to a remarkable figure of $112 billion this year.

“India’s economic dependence on China has continued to deepen, at a time when political, security and investment relations between the two countries are at their lowest levels,” Kevin Zhongzhe Li, a Washington-based scholar at the Asia Society Policy Institute and China Analysis Centre, told the BBC.

More worryingly, India's exports to China have remained below pre-Covid-19 levels, while imports have doubled during the same period.

“China now provides more than 30 percent of India's industrial imports, and India depends on it for more than 100 vital products, and the imbalance is getting worse,” says Ajay Srivastava, of the Delhi-based Global Trade and Research Initiative Foundation.

According to Srivastava, if import growth continues at this rapid pace, the trade deficit between the two countries could rise to $134 billion, which could give Beijing greater influence over Indian industry.

On the sidelines of the BRICS summit in Delhi in September, and with relations between the two Asian giants increasingly improving, Indian Prime Minister Narendra Modi and Chinese President Xi Jinping pledged to address “structural imbalances in trade and supply chain problems.”

But experts told the BBC that this would be a daunting task for Delhi, given how entrenched Chinese imports are in India's industrial economy.

This is mainly because India's dependence on China is no longer limited to the consumption of finished products, but is increasingly extending to the production of industrial goods themselves.

It is true that India has reduced its dependence on imports of some final goods, such as smartphones and solar energy equipment, and now produces more than a quarter of the world's iPhones.

But Srivastava says: “Production is still largely assembly-based, and highly dependent on imported components, particularly from China.”

The same is true in the industrial machinery, battery inputs, chemicals, solar cells and manufacturing equipment sectors.

According to the Observer Research Foundation, electrical machinery and electronics alone constitute 36 percent of imports, followed by machinery and mechanical devices at 21.7 percent, while organic chemicals and plastics also account for a large share.

“The disruption of these imports will not only affect consumption, but will modify the production process itself,” says Soumya Bhowmik, a researcher at the Foundation’s Center for New Economic Diplomacy, considering that this reflects the difficulty India faces in replacing Chinese inputs with local production.

Besides increasing dependence on inputs and raw materials, other macroeconomic trends are also driving increased Chinese imports to India.

China possesses huge surplus production capacities in sectors ranging from steel to solar panels and electric cars, at a time when its slowing economy cannot absorb all this production.

Therefore, Chinese manufacturers are increasingly turning to foreign markets and selling their products at low prices, and it is expected that China's trade surplus will exceed one trillion dollars for the second year in a row.

A large portion of these goods are reaching the Indian market due to the rapid expansion of manufacturing across different sectors of the economy, and also because “Western markets impose customs duties and other restrictions,” according to Srivastava.

In contrast, poor access to the Chinese market remains a major challenge for Indian companies.

“Indian products face a range of tariff and non-tariff barriers in China, making it difficult to increase exports on a large scale,” says Lee.

He adds: "If normalization of relations continues without a serious push towards mutual access to markets, India may face a situation in which the political relationship improves while economic dependence remains unchanged."

The long-term solution, whether to reduce avoidable imports or improve export performance, is to strengthen the manufacturing sector, says Srivastava.

But this requires a tailored industrial policy for each sector, as well as improving economic fundamentals, such as providing affordable energy and credit, increasing the efficiency of logistics services, and ensuring stable regulatory rules - areas where India still suffers from shortcomings.

But he adds: "Reducing the $112 billion deficit will not be achieved simply by finding limited export sectors."

He continues: "The key question is whether Beijing is ready and willing to make concessions on market access as part of the broader normalization of relations. Otherwise, India will need to find its own pressure tools to force the opening of this debate."