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CIAO DATE: 2/00
Regional Trade Integration: Modest Progress
The South Asia Monitor
Number 9
May 1, 1999
South Asian exports face a challenging external environment. World growth and demand have weakened, commodity prices are expected to decline further, and the phasing out of the textile quota system in 2005 will leave many of these countries’ exports more vulnerable to competition from other developing countries. Export growth in the region has slowed; yet reviving export growth will be crucial to boosting the region’s sagging GDP growth rates, which have fallen from about 7 percent in 1996, to 5 percent in 1997–1998, and are widely expected to fall further in 1999.
Greater regional trade integration—initially under the aegis of bilateral preferential agreements, followed by the establishment of a free trade area—has been proposed by many as a panacea for sagging export growth. Preferential trade agreements are expected to have rather modest an economic impact, with some benefits for consumers and some increased competition for domestic producers. Overall, integration among the South Asian countries is unlikely to yield big trade gains, whereas integration with the developed economies could lead to significant trade creation. Moreover, a preferential agreement is likely to accentuate current trade imbalances in the region. Aside from trade agreements, there is potential for economic cooperation in specific sectors, most notably energy. Politically, preferential trade can help sustain the improved political relations the region’s leaders all say they want. The following discussion focuses on the four largest South Asian economies: India, Pakistan, Sri Lanka, and Bangladesh.
Background:
All South Asian countries, with the exception of India, rely on a narrow export base consisting largely of commodity crops and textiles. The region’s main imports are petroleum and petroleum products, capital goods, iron and steel, and textile fabrics for Sri Lanka and Bangladesh. The narrowness of these nations’ export bases increases the vulnerability of their balance of payments to shocks. Successive crop failures in cotton, Pakistan’s main export, have diminished the country’s export revenues. Bangladesh and Sri Lanka, where textiles and the garment industry are the largest foreign exchange earners and account for a significant share of total industrial production, are likely to be severely hit by the phasing-out of the global textile quota arrangements under the Multi-Fiber Arrangement by 2005. Export growth in India and Pakistan has steeply fallen, largely because of a weakening in the thrust of trade reform, and deeply rooted structural constraints. The entire region has been affected by greater competition from the devalued East Asian currencies and a contraction in world demand, particularly in East Asia, Russia, and Japan. If the projected declines in global commodity prices materialize, the region’s export outlook appears fragile. Over the medium-term, the region should widen its export base by diversifying into higher value-added exports, which are less price-sensitive and afford a more stable source of export revenue. Strengthening the export base will be particularly important in view of the limited availability of external financing.
Why is regional trade so low?:
Greater regional trade integration has often been put forth as a means of boosting and stabilizing the countries’ exports, and offsetting the import contractions in other markets. Attempts have been made to encourage regional trade under the aegis of the South Asian Association for Regional Cooperation (SAARC), established in 1985. The SAARC’s member countries are India, Pakistan, Bangladesh, Sri Lanka, Nepal, Bhutan, and the Maldives. The South Asian Preferential Trade Agreement (SAPTA) was drawn up in 1993, providing for bilateral reductions in tariff and non-tariff barriers on specified commodities on a reciprocal basis, but with special treatment given to the least developed states. The eventual objective is for SAPTA to become by 2001 a South Asian Free Trade Area (SAFTA), based on multilateral tariff reductions. On the whole, the achievements of SAARC and SAPTA have been limited. Although tariff concessions have not been negligible, they have been introduced on items that represent no more than 1 percent of the total trade of the seven-country grouping. Despite official declarations, the establishment of a free trade area in South Asia (SAFTA) by 2001 appears highly unrealistic.
Trade within the South Asian region has been limited by a host of economic and political factors. Although there is substantial informal trading, official trade among SAARC countries today accounts for less than 4 percent of their total trade volumes. The region’s principal export destinations are the United States, the European Union, and Japan. On the political side, the main obstacle to greater trade integration has been the tension between India and Pakistan, and to a lesser degree, distrust of India by her smaller neighbors. On the economic side, perhaps the main inhibiting factor has been a lack of complementarity in the countries’ exports. The four major South Asian nations export a similar basket of commodities, and often compete directly in third markets, especially for textiles. Furthermore, India’s economic preponderance and comparative advantage in a range of products has resulted in asymmetric trade relations with her neighbors, hindering regional integration. Regional trade has also perhaps not taken off because all the countries in the region had been pursuing, until the late eighties, import-substitution policies aimed at promoting domestic industries. Last, low growth and demand within the region itself, and historical trade links with the developed countries, have resulted in extra-regional patterns of trade.
What are the implications of SAPTA?
A preferential trading agreement in South Asia is unlikely to contribute significantly to intra-regional trade. While there is scope for enhanced trade between India and her neighbors—particularly in transportation equipment and engineering goods, including information technology (IT) products—the additional trade is likely to represent a small percentage of the countries’ total trade. Over the longer term, regional trade liberalization could result in dynamic gains from increased foreign direct investment and economies of scale through access to a larger market. On balance, however, trade ties with the developed economies are likely to yield greater economic benefits to the region.
A preferential trading agreement that sought to reduce tariff and non-tariff barriers on a product by product basis would undoubtedly benefit consumers in the region who would gain from a cheaper and wider variety of imports. For Pakistani consumers, trade liberalization with India could result in significantly lower prices for scooters and bicycles, because Indian prices are about 50 percent lower than those prevailing in Pakistan. In Bangladesh and Sri Lanka, consumers could gain from cheaper consumer goods. Protected domestic industries and sectors would have to restructure in the face of greater competition. In Sri Lanka, tariff concessions granted under SAPTA will hurt domestic textile manufacturers, but benefit garment manufacturers who would gain from cheaper imported inputs. In all the countries, trade liberalization will face mounting political opposition.
The SAARC members’ trade imbalances with India would probably increase. Although under a preferential trading agreement India’s neighbors would have greater access to the large Indian market, it is likely that the flow of trade will remain lopsided. India exports a broad range of commodities to Bangladesh and Sri Lanka, including transport equipment, cotton yarn and fabrics, pharmaceuticals, machinery, iron and steel products, and food commodities, but its imports from these countries are limited. India is the leading source of imported goods for both Bangladesh and Sri Lanka and both run significant trade deficits with India. In the first three quarters of 1998, India’s trade surplus with Bangladesh stood at U.S.$488 million, with exports of U.S.$537 million and imports of U.S.$49 million; its trade surplus with Sri Lanka stood at U.S.$335 million, with exports of U.S.$375 million and imports of U.S.$40 million. In the case of Pakistan, political restrictions have kept overall trade very low, and have resulted in a small bilateral deficit for India with exports of U.S.$101 million and imports of U.S.$161 million.
High tariff nations, such as India and Pakistan, would lose import tariff revenues from any tariff reductions. Unofficial trade between India and her neighbors (particularly Bangladesh and Pakistan) could, however, be converted to official trade resulting in significant revenues for the governments concerned. Although India’s direct official exports to Pakistan were just over U.S.$100 million in 1996, an estimated U.S.$1 billion in intermediate and capital smuggled goods pours into Pakistan from India every year via third countries. Trade liberalization that converted all smuggled goods into legally imported goods at a given import duty could yield significant customs revenues for Pakistan and open the way for Indian exports to Pakistan, estimated at US$2.5 billion a year.
Because India will likely continue to be the major regional trading partner for all of the SAARC members, a useful step toward greater regional integration would be for India to grant tariff concessions on a non-reciprocal basis. The philosophy behind Indian trade policy in the region has been evolving: in December 1998, India agreed to withdraw all non-tariff barriers from Bangladesh’s exports. Also in December 1998, it signed a free trade agreement with Sri Lanka aimed at eliminating tariff barriers on the export and import of goods between the two countries. Under the agreement, India has been given three years to bring down tariffs to zero, while Sri Lanka has been given eight years. The agreement is widely seen as an important step in granting Sri Lanka greater access to Indian markets. Tariff concessions alone will, however, not lead to greater trade integration—non-tariff barriers, foreign exchange restrictions, policy discrepancies, and physical infrastructure constraints also need to be removed. A welcome step is the recently concluded agreement in December 1998 between Bangladesh and India to open up four new land routes between the two countries in 1999 in an effort to facilitate bilateral trade.
Besides the issue of trade linkages, there are several possibilities for enhanced economic cooperation in the region, most notably in the energy sector. India, whose current power shortfall (estimated at 10 percent) is rapidly increasing in the face of burgeoning demand, could purchase power from Pakistan and natural gas from Bangladesh. India is presently negotiating with Pakistan the purchase of 300 megawatts of power annually over the next 10 years. There is also potential for Bangladesh to export part of its natural gas reserves to India, a subject that has generated considerable political controversy within Bangladesh.
Political impact
In the short term, the economic impact of freer trade within South Asia is likely to be modest, especially for the large Indian economy. The more important effect of trade liberalization, if it continues to move forward, is political. The impetus for all the recent agreements between India and Sri Lanka and between India and Bangladesh, as well as the high profile SAARC has given to its trade initiatives, comes from the political level. The bureaucracy and business community has gone along with evident reluctance. Continuing liberalization can serve as a demonstration of India’s interest in creating constructive relationships in the area. For India-Pakistan relations, expanded trade can also start to create linkages between the trade and business communities in both countries, creating some of the political and economic “infrastructure” needed to sustain improved relations.
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