A win-win FTA

In contrast to the sometimes difficult political relations between India and Sri Lanka, economic ties between the two have expanded impressively in recent years. Despite a number of problems, the Indo-Lanka free trade agreement, which came into effect in 2000, has become a model of economic cooperation – one that has benefited the smaller partner relatively more than the larger one.

India's political relations with its southern neighbour have had their share of difficulties. Colombo has occasionally accused New Delhi of turning a blind eye to the overt and covert material and moral support given to the LTTE by supporters of their separatist militancy in Tamil Nadu. Indian fishermen have been frequently arrested for fishing in Sri Lankan waters. There are also outstanding issues relating to the settlement of Sri Lankan refugees in Tamil Nadu, and the granting of citizenship to Tamil-speaking people of Indian origin in Sri Lanka.

On the economic front, however, Indo-Lankan relations have increasingly been on an even keel. The bilateral trade and investment links have deepened and widened considerably over the last seven years, despite areas of contention and dispute. The signing of the bilateral free trade agreement (FTA) marked a turning point in economic relations between the two countries. The FTA is considered to be a shining example of economic cooperation in Asia: while it has helped both countries expand trade, as suggested above, Sri Lanka has gained disproportionately. This is arguably the most noteworthy aspect of the FTA, although there have been surges in the import and export of certain items that have disrupted industries – and jobs – in both countries.

For the first time in a decade, Sri Lanka's exports to India dropped in 2006 – from SLR 56.2 billion in 2005 to SLR 50.9 billion in 2006 – primarily due to problems with exports three commodities that can be imported duty-free under the FTA: copper, pepper and vanaspati, a cooking medium made from vegetable oil. India's exports to Sri Lanka, on the other hand, went from SLR 145.6 billion to SLR 187.6 billion during this period.

India and Sri Lanka have historically had close economic ties, and during colonial rule the production structures of both countries were subservient to British interests. But while India started opening its economy to the world during the late 1980s, this process began in Sri Lanka much earlier. In 1977, the Sri Lankan rupee was unified and subjected to a 'managed float', which was followed by privatisation and deregulation of various sectors of the economy. Unlike India's, international trade accounts for a substantial segment of Sri Lanka's economy. Foreign trade as a proportion of gross domestic product is barely one-fifth in India, against three-fourths in Sri Lanka.

From the late 1960s until the end of the 1990s, there were a number of inter-government joint committees and commissions to facilitate trade, investment and technical cooperation between India and Sri Lanka. Since the free trade agreement was signed in 1998, it has largely received the support of the political classes in both countries, even after the national governments of both countries were subsequently voted out of power.

Total trade volume
Whereas the bargaining process to finalise the 'negative lists' – that is, those items that would be excluded from the free trade agreement – was supposed to last only two months, the process ultimately took much longer, and the FTA did not become operational for an additional 14 months after the signing in December 1998. During this period, fears were expressed that the Sri Lankan economy might be swamped by exports from India. In particular, Colombo appeared reluctant to give up revenues that accrued from imports of automobiles. As far as India was concerned, there were apprehensions that 'cheap' tea from Sri Lanka would ruin the fortunes of tea plantations, especially those in South India, and similar fears were raised about the fate of garment manufacturers.

Eventually, tariff rate quotas were imposed on trade in tea and garments, meaning that duty concessions were allowed on trade in these two items subject to quotas. Rules of origin were also specified that were broadly aimed at encouraging the two countries to source raw materials needed for exports from each other, rather than from third countries. Colombo agreed to increase the 'margin of preference' for bulk imports of cement from India, and New Delhi agreed to offer more ports of entry for Sri Lankan tea and garments.

India, which was mainly exporting agricultural items to Sri Lanka until the late 1980s, is currently a major supplier of industrial goods and services. Sri Lanka's main imports from India include machinery, cotton yarn, fabrics and certain garments, primary and semi-finished iron and steel, sugar, wheat, pharmaceuticals, fine chemicals, cement, and paper and wood products. India's principle imports from Sri Lanka are non-ferrous metals (mainly copper), spices (mainly pepper), refined vegetable oil, electronic goods, electrical machinery, scrap metal, paper pulp and chemicals.

For India, Sri Lanka is a relatively small market, accounting for roughly two percent of total exports and less than one percent of total imports. In 1998, India was ranked 21st for Sri Lankan exports. By 2000, however, this ranking climbed to 16th, then to 4th by 2004 and 3rd the year after, preceded only by the US and UK. After the implementation of the Indo-Lankan FTA, Sri Lanka's imports from India have stabilised at around 15 percent of total imports. India is now the largest source of imports for Sri Lanka, followed by Singapore, Hong Kong and Iran.

The most impressive outcome of the free trade agreement has been the sharp rise in the total volume of trade. Total bilateral trade between India and Sri Lanka had been more or less stagnant at around USD 500 million a year during the latter half of the 1990s. This figure doubled to USD 1 billion by 2002, and nearly doubled again to almost USD 2 billion by 2005. Close to 90 percent of Sri Lanka's exports to India and roughly 45 percent of India's exports to Sri Lanka are covered by the FTA.

India's exports to Sri Lanka rose from INR 22.6 billion in 1999 (before the FTA) to INR 59.5 billion in 2004 – an annual increase of 40 percent. Imports, meanwhile, rose from INR 2.2 billion to INR 16.8 billion – nearly 170 percent per year. Thus, in this five-year period, India's exports to Sri Lanka doubled, while imports from Sri Lanka went up fivefold. The dramatic manner in which the pattern of trade between the two countries changed is evident from the fact that the trade balance in India's favour declined from 15:1 in 1998 to 3.5:1 in 2004 (see Table 1).

Tea and vanaspati
Despite the overall gains that accrued from the Indo-Lankan free trade agreement, problems cropped up with respect to trade in specific items. There was a spurt in exports of cement from India to Sri Lanka from INR 692 million in 2000-01 to INR 1.3 billion in 2003-04 – a climb of more than 80 percent. The Indian market has also been flooded with copper, pepper and vanaspati (see Table 2).

At present, more than half of Sri Lanka's exports to India is copper and copper products. Copper imports have risen from nil to INR 4.8 billion in 2005-06, and Sri Lanka now has more than an 80 percent share in India's total copper imports. Imports of pepper have gone up almost threefold, from INR 160.5 million in 2000-01 to INR 445.6 million in 2005-06, increasing Sri Lanka's stake in India's pepper imports from 26 to 37 percent.

Contrary to initial expectations, exports of tea and garments have not surged, with imports of both of these items still less than five percent of the quotas specified in the FTA. In fact, Sri Lanka's tea exports to India have come down, from INR 87 million in 1999-2000 to INR 38.9 million in 2005-06. In a development that caught nearly all involved off guard, Sri Lanka's share of total tea imports by India crashed from 34 percent to barely 3.7 percent during this period.

The most contentious issue plaguing the FTA has been exports of vanaspati from Sri Lanka to India. Since Sri Lanka does not levy any customs duty on imported palm oil used in the manufacture of vanaspati or other products, following the implementation of the FTA ten manufacturing units were set up in Sri Lanka (with an investment of around USD 100 million), specifically to export these items to India at low prices. Interestingly, most of these units were set up by Indian businessmen. Exports of vanaspati went up from 80,000 tonnes in 2002 to 165,000 tonnes in 2005 – by which time Sri Lankan vanaspati was accounting for around one-sixth of India's total annual vanaspati market. In value terms, vanaspati exports from Sri Lanka to India rose from INR 120,000 to INR 6.6 billion between 2001 and 2006, and Sri Lanka's share in total imports of vanaspati by India jumped from nil to 63 percent during the same timeframe. 

In June 2006, New Delhi decided to restrict Sri Lankan vanaspati by canalling all imports through the National Agricultural Cooperative Marketing Federation. The ten vanaspati units in Sri Lanka subsequently shut down operations, with the owners complaining about New Delhi's "unilateral" decision to raise this non-tariff barrier in "violation of the spirit of the FTA". The FTA specifies that up to a limit of 250,000 tonnes of vanaspati can be exported from Sri Lanka to India, although only 100,000 tonnes had actually been shipped in at that point. While the Commerce Ministry in New Delhi contends that this quantity is adequate to ensure capacity utilisation, vanaspati manufacturers in Sri Lanka claim the quota can be finished in six months. After initial resistance, Sri Lanka agreed to cap exports of vanaspati and bakery shortening to 200,000 tonnes a year in late 2006.

Duty-free imports of high-quality black pepper from Sri Lanka was also resisted by farmers in Kerala and Karnataka, resulting in an imposition of an annual limit of 2200 tonnes of pepper imports by India from Sri Lanka. Copper exports from Sri Lanka to India have also been controversial, since businesspersons have imported copper scrap to Sri Lanka without paying any import duty, and then melted and re-shaped this into ingots for sale to users in India. Sri Lanka has no copper mines of its own, and there have been allegations that these smelters violated the rules of origin in the FTA by not adhering to the stipulated value addition norms of around 35 percent. Twenty secondary copper smelters were set up in Sri Lanka by Indian businesspersons after the FTA. After India slashed import duties on copper scrap in 2006, most of these smelters became unviable and had to shut down. Imports of copper items by India from Sri Lanka subsequently jumped from less than USD 2 million in 2000-01 to nearly USD 19 million in 2002-03 and USD 82 million in 2003-04.

Comprehensive partnership
Despite the glitches, there is much to be applauded in the newly articulated economic relations between India and Sri Lanka, as evident in the signing and implementation of the FTA. India became the largest foreign direct investor in Sri Lanka in both 2003 and 2004, with investments of around USD 200 million; currently it is in fourth place after Singapore, the UK and Australia. Major Indian investments in Sri Lanka include a 300-megawatt power plant; while India's Oil & Natural Gas Corporation, Ministry of Railways and the Delhi Metro Rail Corporation are also looking at possible collaborative ventures. India is also engaged in building hospitals and educational institutions in Sri Lanka. The investments by Sri Lankan businesses in India are relatively smaller, but have taken place in units producing biscuits, apparel, pre-fabricated furniture and stainless steel.

It is argued that India could reap re-export benefits through Sri Lanka, which has been granted "GSP plus" – GSP stands for generalised scheme of preferences – status by the European Union, thereby enabling it to export at relatively low duty rates. Further, the 2005 free trade agreement between Pakistan and Sri Lanka could help the latter position itself as a conduit for a significant amount of India-Pakistan trade that currently gets surreptitiously diverted through Dubai and Singapore.