South Asia Free Trade Area - Case Study Example

South Asia Free Trade Area 2009 Table of Contents Page Introduction 3 Theories of Free Trade Agreement 4 Trade Diversion and Trade Creation 5 Advantages of SAFTA 8 Disadvantages of SAFTA 10 Effects of WTO 11 Conclusion 11 Introduction The Islamabad Declaration of 2004 by the seven South Asian Association for Regional Cooperation (SAARC) countries that had come together in the mid 1980s – India, Pakistan, Bangladesh, Sri Lanka, Nepal, Bhutan and the Maldives – formed the South Asia Free Trade Area (SAFTA) which was eventually launched in January, 2006. Following the Common Union model of regional cooperation first formed by the European Union, several trading blocs were formed across the world in the 1990s as multilateral trade negotiations under the GATT was continuously delayed during the Uruguay (1986-93) and Doha (1993-97) rounds. Like the North African Free Trade Agreement (NAFTA) between the United States, Canada and Mexico, the MERCOSUR between Latin American countries, Argentina, Brazil, Mexico, Paraguay and Uruguay, and Middle East and North African (MENA) countries, SAFTA was also formed on the basis of the gravity theory of international trade that postulated that most trade occurred within geographical proximity than with countries that were far apart. However, trade between South Asian countries has contributed only 5 percent of the countries’ total trade (USAID, 2004). In fact, regional trade between these countries has gone down greatly from the pre-Independence level when these countries were united. Over the years, political tension between the countries, particularly between India and Pakistan, has hindered free flow of trade between the countries. As a result, success of an economic and trade cooperation in the region depends more on political parameters and elements that are outside the ambit of the trade agreement. Yet, the formation of the SAFTA was justified on the basis of immense possibilities of intra-regional trade and development of a multilateral framework within the region. In this context, I will analyze the SAFTA in the perspective of the aims of free trade theory, development imperatives of the region and the theoretical arguments for a trading bloc. To begin with, I will present the theoretical perspectives of Preferential Trade Agreement and Free Trade Area and the effects of such agreements on trade creation, diversion and expansion. Thereafter, I will discuss the reasons why SAFTA has had limited success so far. Theories of Free Trade Agreements Regional trading cooperation has been through progressive arrangements - Preferential Trading Arrangement (PTA) as agreements between two or more countries to trade between themselves at lower tariff rates than with the outside world, Free Trade Agreement (FTA) to reduce the bilateral or multilateral tariff rate in the region eventually to zero and a customs union (CU) which is an FTA in which the member countries not only trade at zero tariff rates between themselves but also have a common external tariff rate (Panagriya, 1999). Thus the PTA is the mildest form of regional trade integration and provides the building blocks for trade liberalization and creation of a free trade area (Mukerjee, 2004). The NAFTA and MERCUSOR are FTAs while the European Union is a customs union with monetary union in addition. Thus, a PTA progresses to a FTA and then to a CU as the regional trading bloc develops. In practice, PTAs rarely eliminate trade barriers between member countries completely. Most often, non-tariff barriers pose the greatest difficulty. For example, trade between India and Pakistan is hindered by historical political tension between the two countries since their inception. Among the seven countries of the SAFTA, two (Sri Lanka and the Maldives) are island countries, two (Nepal and Bhutan) are land-locked and India has borders with four countries (Pakistan, Bangladesh, Nepal and Bhutan). Yet, over the 62 years of Independence and despite the formation of the SAARC, the countries do not have transit rights through others in the bloc. As a result, regional trade gets limited as, for instance, Nepal which has rich hydropower resources cannot export electricity to Bangladesh because India does not provide it transit rights. Similarly, Pakistan cannot export cotton products to Bangladesh because of lack of transit rights through India. Thus, PTAs need to be accompanied with other policies, most often political policies that are more cumbersome than trade agreements. The success of the European Union has hinged on the harmonization of product standards, introduction of competition and social policies like health standards (which are essential for the free movement of people within the union), free movement of people, services and capital and monetary union (Panagriya, 1999). Trade Diversion and Trade Creation It has been argued that trading blocs that are based on PTAs tend to divert trade from those possible with other countries at lower costs hence have an adverse welfare effect (Panagriya, 1999). Trade diversions can be minimized it the trading partners are within geographical proximity and are “natural trading partners”, that is they already undertake a lot of trade between themselves. Such is not the case of the SAFTA partners as all of the countries have far higher trade with outside countries, particularly the United States, than between themselves. Besides, there is always the possibility that a trading bloc may give undue advantage to the member countries over those outside if the former can import products from a low-tariff country within the bloc and then export to a high-tariff country outside, which is termed as trade deflection. It is then protected against foreign competition as well as in an advantageous position as a member of a PTA. To prevent this, the WTO has imposed the “rules of origin” clause by which a product can be traded within the bloc with no tariffs only if a specified amount of its value addition originates within the bloc (Panagriya, 1999). Empirical studies have found contradictory evidence of the formation of the SAARC and the SAFTA in trade diversion or creation. Hassan (2001 cited in Das, 2007) found that the formation of SAARC reduced intra-regional trade as well as trade with the rest of the world in 1997 while HIrantha (2004 cited in Das, 2007) found through the gravity model from panel and cross section data for 1996-2002 that regional integration was trade creating among the SAARC countries without any trade diversion from the rest of the world (Das, 2007). Pigato et al (1997 cited in Das, 2007) found that SAFTA resulted in welfare gains in the member countries and the gains have been larger in countries where liberalization has been greater and faster. However, most empirical studies have found that welfare gains have been mainly on account of trade liberalization with or without accompanying FTAs but not on account of FTAs alone. The political relations between India and Pakistan have been particularly a contentious issue that has left much to be desired for PTAs to be successful between these two countries (Mukerjee, 2004). Batra (2004) tested the gravity for India’s trade and found that India’s trade potential is highest with the Asia Pacific region followed by western Europe and North America. Among the SAARC countries, India’s trade potential is highest with Pakistan. Rahman et al (2006), too, tested the gravity model to find net trade diversion from the region as a result of PTAs. The formation of the FTA involves a trade liberalization program (TLP) along with minimizing the sensitive list that would exempt products to be included in the TLP, rules of origin, institutional arrangements to facilitate TLP, trade facilitation through harmonization of product codes and reducing transaction costs, dispute settlement, safeguard measures and simultaneous reduction in barriers to foreign investments. The following table shows the simulation of the net effect of SAFTA on TLP (Rodriguez-Delgado (2007). New Exports New Imports New Trade Flows Bangladesh 0.66 18.64 19.31 Bhutan 0.84 3.58 4.41 India 38.89 7.54 46.43 Nepal 4.59 11.23 15.91 Pakistan 3.26 1.51 4.77 Sri Lanka 1.71 5.27 6.98 Maldives 0.09 2.10 2.19 South Asia 50.15 49.85 100.00 Thus, the formation of SAFTA has increased India’s exports and imports from Bangladesh and Nepal. Very little trade originates from Bhutan, Maldives, Sri Lanka and Pakistan. Only the smallest countries, Bhutan and Maldives, and witness increased trade flows in proportion to GDP. These smaller countries have always depended on imports from neighboring countries hence SAFTA has facilitated increased trade flows. Advantages of SAFTA The SAARC had for long been seen as a regional forum for discussions and seminars rather than a serious attempt at trade and economic cooperation and the formation of the SAFTA was the first step towards that end. In the region, India, Pakistan and Bangladesh are the bigger powers while the other four members of the union have little resources and capital. According to World Bank categorization, India and Pakistan are low-income countries, the Maldives and Sri Lanka are lower middle income countries while Nepal, Bhutan and Bangladesh are the least developed countries (Das, 2007). Only since the 1990s, the south Asian countries began to take active interest in multilateral trade negotiations. However, the activism remained limited to the GATT rounds at Uruguay and Doha. Regionalism had not yet taken a firm root despite the formation of the SAARC. On the other hand, most of the region’s trade has been with the external world, particularly the United States. The South Asia Preferential Trade Agreement (SAPTA) was signed in 1993 but it did not become successful because the continuation of protectionist regimes in most countries and political disputes between them. Besides, India had imposed a ban of import of consumer products till 2001. The SAPTA was signed product-by-product although the ultimate aim was to convert this into a FTA. Before the creation of SAFTA, there have been three rounds of customs notifications in the member countries that introduced PTAs between countries. Through the notifications, 5550 products were offered for PTAs between countries while 3439 countries were related to only least developed countries (Mukerjee, 2004). Theoretically, the import price in the receiving country should fall leading to welfare gain in the receiving country. Through the three rounds of SAPTA, there was limited success as the member countries did not reduce tariffs fast enough. Whatever tariffs were cut, with little depth, these were not related to actual trade between the countries. Non tariff barriers were not addressed and the “rules of origin” were not clearly specified (Dushni). SAPTA became SAFTA in 2006 and is scheduled to have full trade liberalization by 2016. Along with this, India has had bilateral trade negotiations with Bangladesh, Bhutan, Nepal and Sri Lanka while there have also been trade negotiations between Pakistan and Sri Lanka. India has also signed FTAs with south east Asian countries like Thailand and Singapore, indicating that its policies are not limited to form a trade bloc in south Asia alone (Das, 2007). India is unique in the region as it had a fairly successful import substitution policy regime earlier, that enabled it to form a base of heavy industries. It exported simple products, mainly commodities till liberalization in 1991. Since 2000, the country has witnessed fast pick up of economic growth, on the basis of being a low cost outsourced production base for multinational companies as well as increased foreign investments, both direct and portfolio. India’s trade relations not only increased but also diversified from being mainly with the United States to also including south east and east Asia, primarily China. Both trade and foreign direct investments (FDI) from these regions expanded significantly. As a result of integration with east and south east Asia, India’s integration with south Asian countries has faced a setback, defying the theory of gravity (Das, 2007). Disadvantages of SAFTA A trading bloc can be successful only if each of the members produces complementary products that can be traded against each other. Historically, south Asian countries have exported labor-intensive commodities. This is mainly because of the low level of education and backwardness of industries in these countries. Although India’s and Pakistan’s exports are to some extent complementary to the other countries, it cannot be said the other way round. In fact, most of the south Asian countries compete with each other in the export market since the resource endowments of the countries are similar. Especially in textiles, apparel and light manufacturing products, south Asian countries compete in the export market which comes in the way of regional integration. While all of the countries compete in trade with rest of the world in labor-intensive exports, intra-regional trade has not provided the same opportunities. As a result, intra-regional trade in south Asia, which fell to 2 percent of total trade in the post World War II period has increased only marginally to 5 percent (Das, 2007). Differences in factor endowments between countries in this region and that of the United States and the European Union has meant that the south Asian countries trade more with these countries than between themselves. While these countries import manufactured commodities and oil from industrial countries, export of labor-intensive commodities also find larger markets in these regions. Even though the smaller countries like Bangladesh and Sri Lanka imported 20 percent and 15 percent of total imports from India in 2002, India’s exports to these countries contributed only a small fraction of its total exports. Hence, this cannot be considered as true regional trade integration. India’s exports to countries in the region increased marginally from 3 percent in 1990 to 5 percent in 2002 as a result of unilateral tariff reductions (Das, 2007). The most crucial problem for the lack of possibility of success of the SAFTA is that the size of the regional economies are small and hence they have to crucially depend on industrial economies for big ticket imports of petroleum and manufactured products. An FTA in this region would therefore be trade diverting than trade creating. Only if economic growth of all the countries is fast enough and these reach middle income status can the large population in this region enable trade creation. Most of the countries, like Bangladesh, continue to have high tariff rates and many tend to exclude products from the ambit of the FTA depending on the lobbying power of industries and business houses. Effect of WTO The aim of the General Agreement on Tariffs and Trade (GATT), established in 1947 which formed the World Trade Organization (WTO) in 1994, was to enable free trade between all countries and dispute settlement on a multilateral framework. This was why GATT initially forbade member countries to pursue discriminatory trade policies against each other and it abolished the Most Favored Nations (MFN) clause that had been prevalent in bilateral trade. Yet, as more and more regional trading blocs came into existence, partly in response to the hegemony of the United States that dominated global trade, PTAs and FTAs had to be accommodated with the clause that regional trade would not necessarily raise tariff rates with countries outside. Conclusion The SAFTA has had limited success so far. This is because the countries of the region has not yet reached sufficient degree of economic growth and the factor endowments postulate that these have to depend on imports from industrial countries. Exports from these countries also find a larger market in the industrial countries than in the region because of low purchasing power in member countries. Although historically these countries have had greater trade relations with Western Europe and North America, fast growth in East and south east Asia has meant that these regions provide a greater trade potential for the countries individually than intra-region trade. However, empirical evidence on the effect of the formation of SAPTA and SAFTA on trade creation or diversion has been mixed. Works Cited Panagriya, Arvind, Regionalism in Trade, World Scientific, 1999 USAID, South Asian Free Trade Area: Opportunities and Challenges, 2004, http://pdf.dec.org/pdf_docs/PNADE563.pdf CIA, World Factbook, https://www.cia.gov/library/publications/the-world-factbook/geos/ Das, Dilip K Das, South Asian Free Trade Agreement: Prospects for Shallow Regional Integration, Working Paper No 143, University of Murdoch, Australia June 2007, http://wwwarc.murdoch.edu.au/wp/wp143.pdf Mukerjee, Indra Nath, South Asian Free Trade Area and Indo-Pakistan Trade, The Pakistan Development Review, 43, 4 Part II, Winter 2004, http://www.pide.org.pk/pdf/PDR/2004/4/PartII/Mukerjee.pdf Dushni, Weerakon, South Asia Free Trade Area, Paper presented at The Energy Research Institute, http://www.teriin.org/events/srilanka/dushni.pdf Hirantha, From SAPTA to SAFTA: Gravity Analysis of South Asian Free Trade, 2004, http://www.etsg.org/ETSG2004/Papers/hirantha.pdf Batra, Amita, India’s Global Trade Potential: The Gravity Model Approach, Working Paper No 151, Indian Council for Research on International Economic Relations, 2004, http://www.icrier.org/pdf/WP_151R.pdf Rahman, Mustafizur et al, Trade Potential in SAFTA: An Application of Augmented Gravity Model, Center for Policy Dialogue, Bangladesh, http://www.cpd.org.bd/pub_attach/OP61.pdf Rodriguez-Delgado, Jose Daniel, SAFTA: Living in a World of Regional Trade Agreements, IMF Working Paper 07/03, 2007, http://www.imf.org/external/pubs/ft/wp/2007/wp0723.pdf Read More