A Subcontinental free trade utopia

It was unlikely for the plebeians to have missed the self-congratulatory tide which followed the January 2004 Islamabad SAARC summit. The South Asian Free Trade Area (SAFTA) agreement signed by the foreign ministers of the seven SAARC countries was hailed as the biggest outcome of the summit and the framework for the Free Trade Area (FTA) which SAFTA envisions was projected as the remedy to alleviate the economic woes of the region. While the thaw in the relations between the two 'biggest' players in the area was a positive step, setting aside the compulsions of an upcoming election in India and the ex-gratia benefits of good neighbourly behaviour on the part of Pakistan, the agreement on trade liberalisation and intra-region free trade in goods needs to be reviewed in the face of pretentious optimism.

Globally, regional trading agreements (RTA's) have been proliferating over the second half of the 1990s, enabling many states to gain from freer trade. Depending on the level of integration, these have ranged from preferential trading agreements, free trade agreements such as the North American Free Trade Agreement (NAFTA), customs unions such as Mercosur (a Latin American regional integration mechanism with Argentina, Brazil, Paraguay and Uruguay as full members, and Bolivia and Chile as associate members), to economic union such as the European Union (EU). The SAFTA agreement is a higher stage in the evolution of the earlier SAARC Preferential Trade Agreement (SAPTA) of 1993.

Tied down as it was by various political limitations, SAPTA proved inadequate to boost intra-region trade on a commodity-wise basis. The present agreement proposes to address the current low levels of intra-SAARC trade (chart 1), which hovers around the 5 percent mark, through a phasing out of barriers (primarily tariffs and quantitative restrictions) to trade in goods between member nations over a 10 year period. The operation of the draft agreement is subject to its ratification by member states by 1 January 2006.

The agreement requires the 'least developed' countries—Nepal, Bhutan and the Maldives—to reduce tariff rates to the 0-5 percent target over 10 years starting from 2006. Of the 'non-least developed' countries, India, Pakistan and Bangladesh will get five years to implement the new tariff regime while Sri Lanka will get six years to reach the target. Such purposeful time-frames and schedules suggest a gung-ho can-do attitude that does great credit to the Southasian leadership's vision of common future, but can this vision withstand critical scrutiny? The present visualisation of a free trade arrangement in Southasia has been endorsed by many quarters, but is such confidence warranted? The hard realities on the ground do not, prima facie, inspire much faith in the possibility of a workable arrangement emerging in the near future. All the 'feel good' chatter that has come to dominate the Indian media in particular must perforce when it has the time contend with the fundamentals of international trade.

Trade primer

International trade is generated when each country produces that basket of goods in which it has either comparative advantage due to the abundance of certain factors of production, relative production efficiency arising from economies of scale (largely a capital-intensive phenomenon), or the presence of 'unique' natural resources. Two-factor models (which consider only labour and capital) explain how countries which are abundant in labour engage in the production of labour-intensive goods for exports and import capital-intensive goods and vice versa. The complement of this is that economies which are relatively labour deficit manufacture goods amenable to capital-intensive production and import those which are labour intensive from labour surplus developing countries. While this explains the trade patterns between developing countries and their partners in the developed world, the high level of trade between developed economies is explained by the high per capita incomes in these countries which facilitate intra-industry trade, especially in hi-tech goods. The trade in these goods runs up to huge volumes because of high levels of product differentiation which fuels the demand, for example, for smaller mobile phones, bigger sports utility vehicles, or flatter televisions.

Predictably, the direction and volume of trade from the South Asian region is largely towards the capital abundant developed countries of the Organisation for Economic Co-operation and Development (OECD), resource rich Oil Producing and Exporting Countries (OPEC) and East European countries (table 2). The export basket for most of the SAARC member states is composed of primary goods (agriculture and allied products) or low-tech labour-intensive manufactures (textiles, garments, clothing, etc). Their exports are in bulk which means that the component of value-added at the country level is low and hence restricts the export base since the larger and more lucrative value-added market is not available to South Asian countries. Typically, other countries tend to take advantage of this market. Likewise their imports are either intermediate goods (resource/raw material-based) like petroleum and chemicals, or capital goods (machinery/equipment-based).

For the 'contracting parties' (as SAFTA likes to refer to its members) to imagine that the engine of regional growth in South Asia will lie in the trade in goods alone is highly optimistic (table 3). With very few exceptions where a country's advantage lies in unique geographical or resource endowments, it is highly unlikely that an upswing in intra-regional trade can result from comparative advantages when all the economies of SAFTA are still locked into a labour-surplus and capital-scarce environment. With low levels of per capita incomes in most of the member states and fewer numbers of technology driven industries, intra-industry trade based on very refined product differentiation does not seem to have a bright future either. Within the region the only exceptions to the general trend are Nepal and Bhutan whose trade figures with India run at high percentage levels, albeit of low value in terms of the region's overall trade with the rest of the world.

Even if it is suggested that investment decisions do not necessarily follow the patterns that text-book 'theories' have worked out, it would still seem doubtful that investor risk-taking will substantially increase or that outcomes from the consequences of SAFTA will be equitable. For example, it might be argued that differences in the level of unionisation of workers, the relative ease of imparting the necessary skills to labour, and wage rate differentials could lead to geographical distribution of investment to the benefit of other less industrially developed member states like Bangladesh or Pakistan in relation to India. Product-specific relocations of production units cannot be ruled-out, as in the case of a tyre-manufacturing plant shifting base to the Pakistan Punjab to service the demand in both the Pakistan market as well as the north-western sector of India since the costs of setting up manufacturing and training new workers for an essentially mechanised industry will be evened out by the long-run gains from a larger market. Even so, the number of instances of such new investments flowing into non-industrialised areas is likely to be small. To the extent that negative factors impeding investment flows into the less industrialised countries and sub-regions of Southasia override the possible positive factors that could attract investments into these countries, some degree of caution in estimating the likelihood of such 'horizontal' shifts is called for.

India the Big
A large economy like India has a large reserve army of unemployed semi-skilled and unskilled workers. It also has relatively better infrastructure (transport, communication) and far more robust financial systems in place. Given the circumstances, it is doubtful that production structures using these as inputs would forgo these relative advantages to set up shop in Nepal or Bangladesh merely for the sake of regional co-operation, especially when there are no other advantages to be accrued from making such move. Additionally, the high initial costs for 'horizontal' relocation are discouraged by the politico-economic systems in place in many of the member states. With the 15 January statement by the Pakistan Information and Broadcast Minister, Sheikh Rashid Ahmed that, "Nobody should expect that free trade would be held without seeking a resolution of Kashmir problem", the climate for cross-border investment flows is not set to make much headway. Besides, the region was never known for capital movements between the countries of the region in the first place. Businesses that are known for risk-taking are few and far between in these economies.

However, as mentioned earlier, this scenario does not rule out in toto the benefits to smaller countries such as, for example, Sri Lanka gaining from increased investments in the rubber-tyre manufacturing sector or a new tea blending segment emerging in Sri Lanka to the detriment of Dubai, or India's further investments in hydro-electric projects in Bhutan and Nepal with buy-back arrangements. But such developments need not necessarily be attributed to the special effects of SAFTA and the freeing of the regional trade arrangement. Such activities, to the extent that there have been any, have already been going on because they were being facilitated by the bilateral and/or free trade arrangements that already exist between India and these countries. This is a factor that tends not to be considered or disregarded. Any expansion of scale in such investments therefore need have nothing to do with SAFTA and the further freeing of trade arrangements.

All this is not to suggest that SAFTA will have no beneficial consequences whatsoever. The 'premium' (products unique to the region) categories, for instance, stand to gain so that more of Darjeeling Tea, Sri Lankan blend, Nepali carpets, high-quality Pakistani cotton, Bhutani handicrafts and Maldivian tuna may well make their way into each others' market. However if the scope of the agreement pretends to be addressing regional economic growth, one would have expected the visioning exercise to be big as well. The market for 'premium' goods is limited, and fears expressed by countries like Bangladesh, of being swamped by Indian goods, could well become reality. Apart from the limited gains to a limited range of 'premium' goods' gains, cheap imports from larger partners (and the Largest Partner) are bound to affect industries in the relatively smaller economies. These countries are doubly constrained by the fact that higher input expenditures and inferior infrastructure might raise the costs of production and make their goods less competitive.

What the Chinese goods did to the footwear and toy industry in Pakistan could as well be replicated for other goods from bigger partners of Southasia. The point bears repeating that the gains can reasonably be expected to be loaded in favour of big economies. Moreover, the draft SAFTA agreement is not even categorical in addressing itself to member states about restricting the use of anti-dumping measures against the lesser developed members. Even the limited benefits to smaller country exports could be manipulated with the options for all countries to prepare a list of 'sensitive' exports and with an ambiguity that does not categorically bind member states to phase out the list. This is what the draft agreement has to say on the sensitive list:

Article 7
3. a) Contracting States may not apply the Trade Liberalization Programme… to the tariff lines included in the Sensitive Lists which shall be negotiated by the Contracting States (for LDCs and Non-LDCs) and incorporated in this Agreement as an integral part. The number of products in the Sensitive Lists shall be subject to maximum ceiling to be mutually agreed among the Contracting States with flexibility to Least Developed Contracting States to seek derogation in respect of the products of their export interest; and

b) The Sensitive List shall be reviewed after every four years or earlier as may be decided by Safta Ministerial Council (SMC), established under Article 10, with a view to reducing the number of items in the Sensitive List.

Added to this are gaping holes in the definitions of basic terms and caveats that could render the entire agreement meaningless if any of the so-called 'contracting states' chooses to invoke them. There is for instance Article 14, which renders SAFTA meaningless. Titled General Exceptions, Article 14 says,
a) Nothing in this Agreement shall be construed to prevent any Contracting State from taking action and adopting measures which it considers necessary for the protection of its national security.

Discrepancies such as these are ideal for manipulation by trade-law experts to be used to according to the whims of the contracting countries and to the possible disadvantage of the least developed.

Trader lobby

It remains to be seen how the volumes and value of trade in goods, aimed at "regional development" through intra-regional trade will move once SAFTA as it is currently envisaged, is put in place. But it is clear that capturing the markets without actual physical shift in industrial production that could diversify the manufacturing base of the smaller countries—by, among other means, horizontal investments that could effect development through knowledge spillovers (expansion of the skilled labour workforce), backward (supply-side benefits) and forward linkages (high-income spurred investments)—could still be done through the trader lobby in each country, particularly in the small countries.
Typically, the trader has a keen interest in the free trade in goods and unlike the manufacturer will profit from the flooding of domestic markets with the goods from the larger economies. While this would ensure that goods make it to their destinations, how much the traders spawn backward-forward linkages to the benefit of sizeable numbers of people is anyone's guess. Trade revenues tend to eventually reach far fewer people than manufacturing revenues. Therefore, the setback to the economy from an overall decline in the manufacturing sector will not be offset by the boost to the trader lobby, because the benefits simply do not reach far enough.

The agreement in its present form also needs to be scrutinised from two other angles. First, the agreement includes only trade in goods and excludes the crucial services sector. Regional development is claimed to be the ultimate goal, and what makes the draft SAFTA agreement such a surprising document is that it chooses to overlook the existing and potential national competitive advantage that the SAARC member states have in sectors like tourism and hospitality (Nepal, Maldives, Sri Lanka), retailing of electricity (with Pakistan's surplus power, Nepal and Bhutan's hydel-power capacities), transmission/distribution of gas (Bangladesh), and health services (India), and so on and a host of other services which make up one-third (and growing) of Nepal's Gross Domestic Product (GDP) and close to 50 percent (and above) of that of the other SAARC member states (chart 4). This is particularly important since the crucial issue of financing infrastructural investment has not been resolved yet It is quite possible that the task of financing infrastructure investment—should the government undertake infrastructure development or will joint-sector arrangements work themselves out for all countries to be equally attractive to investment (foreign or otherwise)—has not been settled yet.

This issue would not have been quite as daunting as it appears since services by and large are not as dependent on heavy infrastructure as manufacturing is. The further advantage of focusing on services is that they are largely more non-competing in nature as between countries. Hence lifting of barriers to their trade may spur the engine of 'regional growth' as opposed to the possibility of uneven development arising from imbalances in the trade in goods. In this sense, the trade in services would have been a relatively safer exercise from the equity point of view. The point is not about doing one before the other but of a mix of phasing out barriers to key competitive sectors whether in goods or services. As of now SAFTA does not address lifting of barriers to trade in services.

The second angle from which the agreement needs to be examined is the presumed effects of foreign direct investment (FDI). The idea of a free trade agreement is being hyped on its prospective linkage to greater FDI inflows from outside Southasia. The 2004 Index of Economic Freedom drawn up by the Heritage Foundation still classifies India as "mostly unfree" and with the second generation of economic reforms in most of Southasia still far from implementation, the catch-line of 'magnet of investment' should be cautiously used in the context of Southasia. The region attracts only about 2 percent of the total FDI inflows to developing countries and even that is shared largely between India (close to 75 percent), Pakistan and Bangladesh .

Even with relatively lower wages, Southasia has not seen the kind of results that planning commissions and finance departments project in terms of actual FDI inflows. Observers have pointed out that low wages are offset by many factors, including the low productivity of labour and the time and cost overruns resulting from poor infrastructure. Interestingly, the actual FDI inflows to the SAARC member states have been in energy, telecom, health, banking and tourism—which make the arguments for removing barriers to trade in services even more urgent

The modalities of the SAFTA agreement would have to work themselves out over the next 12 years when finally the goal of an FTA would be reached. Will the goods-first model that EU and NAFTA adopted deliver for South Asia? It will be safe to say that the optimal levels will not be achieved. For the sake of promoting 'regional development' through greater trade in goods, are there mechanisms in place for improving the condition of unequal infrastructure levels of the least developed members within SAARC akin to the European Regional Development Fund (which was meant to redress regional imbalances of the least prosperous regions)? The text is conspicuously vague on this issue. It phases out lowering of barriers over a 10-year period for the least developed members and suggests a fund to compensate for loss of customs revenues arising from the reduction of tariffs. As for correcting actual regional imbalances which could then leverage their competitiveness, the text is silent on this count.

Does the agreement recognise the presently high levels of illegal labour migration which could be further accentuated towards manufacturing pockets within the bigger economies such as India? The text has nothing to say on the matter. Likewise, a host of other technicalities are left to the trade-experts to finalise, from "rules of origin" (the criterion which merits the "made in x" label on any country's export item) to "sensitive lists" to "areas for technical assistance", notwithstanding the absence of a timeframe for many modalities. As the SAFTA agreement prepares to undergo ratification by member countries over the next two years, it can only be hoped that a more informed and sustained debate in the region takes place over such issues of trade which affect close to a quarter of the world's population. Needless to say, the need to rework the finer points in the SAFTA agreement is ever more imperative. The idea is regional development, after all.